understanding microcap stocks and tips from the pros

Understanding Microcap Stocks

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Table of Contents Chapter 1: Introduction .............................................................................. 3

Chapter 2: Understanding Microcap Stocks .......................................... 8

Chapter 3: Pro Tips from the Frontlines ............................................... 14

Chapter 4: Surviving Rough Times ....................................................... 23


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Chapter 1:

Introduction


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What makes the stock market work and why should you invest in it? If you’re interested in buying and selling stocks for profit but have no idea how the stock market actually works then you’ve picked up the right book! This book was designed for budding day traders who are interested in dynamic and often challenging microcap stocks or penny stocks. Before we begin our exploration of what penny stocks are, it’s imperative that we review how the stock market works in general so that you will have a better understanding as to what you’re getting yourself into. It’s a known fact that many instructional manuals portray the stock market (e.g. NYSE) as a financial utopia where fortunes can be made overnight. Well, let me be the first to tell you that it can be a great place to invest your extra cash but it’s not a utopia. Investing in company stocks and trading your shares of stock for a profit requires analysis and real work. Traders don’t generate profit from the stock market “on autopilot” as some books claim. The traders who do make a ton of cash do so with a deep understanding of the short-term and long-term trends of the stock market. Mastery of stock market trends requires years of practice and continuous engagement with the stock market itself. If you haven’t started on day one of investing in the NYSE or any other stock market for that matter, I wouldn’t advise you to expect large returns overnight.


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What are shares of stocks? The stock market was borne out of the need for companies and conglomerates to raise capital for growth and progressive expansion. When a small company has just started, the money used as capital is often from existing cash (savings) and loans from financial institutions, individuals and entities. When a company begins to expand because of increased profitability, the capital requirement also begins to rise exponentially. It would be awkward to borrow hundreds of millions of dollars from individuals and haggling with other companies to buy stocks of one’s own company would be laborious and inefficient. Thus, the concept of the stock market was created. The stock market was a public space where shares of stocks from different companies can be openly and freely traded. The main profits that you can acquire from investing in publicly traded stocks are called dividends. Companies who offer publicly traded stocks pay dividends to their investors. What is the main role of investors? Investors are not “shadow buyers” or invisible capitalists, without a say as to what goes on in the company. If a company offers 300,000 shares of stock and a single institution invests in 150,000 shares of stock then that institution owns 50% of the company. By making an IPO or initial public offering of publicly traded shares of stock, companies such as Facebook and Google are able to raise massive levels of capital (we’re talking about billions of dollars) through the stock market.


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Obviously, when a company begins making large amounts of profit and gains traction in its target markets, the value of publicly traded stocks increases. Robust companies that are continually making a profit are attractive to investors especially if the long-term projections for such companies are also favorable. Now, it should be noted that it is quite unusual for a single entity or organization to purchase all publicly traded shares of stock of one company. This usually happens only when a takeover has been discussed or a company merger has been put in place. You will learn all about these potential structural changes in publicly traded companies when you start your journey as a penny stock trader. Is stock trading a “get rich quick” method of generating profit? I have been asked this question countless times, no doubt because of the increase in informational products on the Internet that actually guarantee profit in a short period of time. I do not wish to burst anyone’s bubble but if there’s one thing we traders have learned from past economic events, it’s to never invest everything in the stock market. A day trader can lose his investment easily even when stocks are on an upward trend due to lack of planning. If an event such as the DOTCOM burst of the mid-nineties happens again today then we’re looking at a catastrophic landslide of the stock market that will create an economic shockwave throughout the globe. The fact of the matter is that the stock market, just like any other artificial market, is subjected to the same real-world economic stresses that ordinary businesses and markets experience. The stock market is connected to the larger economy and this connection makes it vulnerable to sudden downward changes.


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If you want a word to describe the stock market, I would suggest the word “dynamic” or even “uncertain.” Stock market trends never sit still and everything is moving, 24 hours a day, 7 days a week. When large investors start pouring money into the stock market, everything can rearrange itself to match the dollar volume of the market and this can easily increase or decrease the value of an investor’s portfolio. As you can easily see, there’s no way for the stock market to ever be the utopian dreamland that many perceive it to be. It is a tough place to generate profit and yet, when you finally “make friends” with it and you fully understand how it works; you can begin creating wealth that you never dreamed possible. Assumptions: This eBook assumes the following: 1. That you are interested in learning more about the stock market and micro-capital stocks or “penny stocks.” 2. That you are using this eBook as a general reference only and not as a source of professional financial advice. 3. That you will be cautious and sensible about your investments and you will consult with relevant professionals before using your own finances to fund any investments in the stock market.


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Chapter 2: Understanding

Microcap Stocks


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What are microcap stocks? “Microcap stocks” is a general term in the stock market used to refer to companies with capitalizations that are much lower than what we are acquainted with in larger indices such as the Dow Jones Industrial Average (DOW). Companies with medium capitalization to large capitalization (i.e. “medium cap” companies and “large cap” companies) have at least $500 million in market capitalization. Companies like Google have capitalization amounting to several billion dollars easily. There are actually hundreds of companies that are classified as “medium cap” and “large cap;” they are formally included in large lists or indices that are used by investors to study the overall trend of the stock market (i.e. through the computation and analysis of market averages). The United States SEC formally classifies a company as “microcap” if the total capitalization is below $300 million. If a company gains traction and is able to exceed the $300 million mark, the company “graduates” from the penny stock market to the larger indices and becomes a “medium cap” or “large cap” company. Now, it should be noted that there are companies that have even smaller capitalization. When a company has a capitalization below $250 million but is no less than $50 million, that company is formally classified as a “nanocap” entity. The SEC creates the distinction between the two but in terms of risk, “microcap” and “nanocap” companies are more or less the same.


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How are penny stocks traded? Microcap stocks, or penny stocks, are often traded through private broker networks and nationally, through the OTC Bulletin Board. The OTC Bulletin Board is the larger network of dealers and agents that displays the volume, price and other relevant information about microcap stocks that you can invest in. The OTC Link LLC on the other hand, is a similar network of smaller dealer networks that provides the same type of information but has its own classification of stocks: OTCQB, OTCQX and OTC Pink. In a nutshell, these categories reflect the transparency and dedication of the small cap companies to their investors. Stocks that are classified as OTCQB are the ones that regularly file financial reports to the SEC itself. This is a huge relief for investors because a company that regularly reports its dividends, losses and earnings are excellent for investment. OTCQX stocks on the other hand are representative of companies that also report their financial standings regularly and have passed the specialized standards set forth by the OTC Link LLC. Companies under the OTCQX are often the ones that are not legally required to report their financial standings to the United States SEC but still exhibit an ideal level of transparency to the public and their investors. The third category of microcap stocks is OTC Pink. OTC Pink stocks represent the “wild west” of the microcap market. The stocks in this group are not required to report to any organization and many of the companies here do not regularly post their financial standings. OTC Pink stocks may not meet the specialized standards of OTC Link LLC because of the financial reporting requirements of this quotation network.


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Why are people both afraid of and excited by microcap stocks? To answer your question as honestly as possible, we have to look at the less than sterling reputation of OTC (over the counter) markets since mid-nineties. Microcap stocks have long been considered “high risk” stocks not because of the chance of companies folding or melting due to poor capitalization but because the whole system that allows people to invest in it was less than ideal. Old traders know that the environment that surrounded that penny stock market was full of tricksters and unscrupulous individuals who often preyed on newcomers. Of course, the people who followed the larger indices weren’t perfect either. However, the penny stock people were often more aggressive in trying to lead people astray (i.e. making bad investment decisions). In 2002, there was a “silent crash” that affected the larger indices and the smaller indices, including pink sheet stocks and general micro-cap stocks. Suddenly, there was less than $100 million in total dollar volume left for micro-cap stocks. This tiny amount of money proved that the microcap market wouldn’t die even if the larger investors were pulling out their high-risk investments. The crash was due to many factors but it was only then that people realized that there should be better financial reporting and the best practices used in regulating the larger stock market indices should also be implemented in the private dealer networks that handled OTC stocks.


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The “crash of 2002” proved to be a beneficial event to the penny stock market, even though it did significantly hit the adventurous traders who were “deep” into microcap stocks. Today, there is now better transparency and financial reporting and the environment that surrounds penny stocks is less aggressive and less focused on tricking new traders. It seems like a “ritual cleansing” occurred and the old tricksters that once made a lot of cash selling bad advice to people were finally evaporated by the temporary lack of interest in penny stocks. What distinguishes microcap stocks from regular stocks from the larger indices? Before you start investing your hard-earned cash on microcap stocks, there are two main things that you should always remember: 1. Information Deficiency – This is by far the biggest hurdle that the microcap market is still trying to overcome through better transparency and improved dealer network systems. Compared to companies that are in the NASDAQ or DOW, it can be extremely difficult to gauge penny stock companies through research. So if you’re planning to invest in a new promising new microcap company, you may not find as much public data about it as you would like, which makes investment riskier. Not all microcap companies are required to report to the United States SEC and so downloading a report from the SEC becomes impossible if this is the case for the company that you are researching.


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Available company information can also be outdated and any professional analysis of the same would be essentially useless as stocks are dynamic and any analysis should be backed by fresh data. 2. Microcap Risk Level – It’s not surprising that the risk for investing in microcap stocks is higher than regular stocks (i.e. medium cap to large cap stocks) as company collapse is more common in this side of the market due to capitalization and profitability issues. For example, a company may have a total capitalization of $150 million and yet, its main product may still be in its infancy, with no guarantee that it’s going to make any traction in the larger market. Venture capitalists can easily provide the hundreds of millions of dollars to startups and yet, the presence of this small seed capital is still not an indicator of success. The age of microcap companies is also an issue – many of these companies are extremely young and in the long term, may not be able to sustain their own operations. When a company begins to slide due to insufficient capital, deficient profit or mismanagement, the value of stocks will also begin to plummet.


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Chapter 3: Pro Tips from the Frontlines


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How can you safely trade microcap cap stocks? When it comes to investing in any type of company-issued stock, risk management is the name of the game. You cannot possibly generate any long-term profit if you don’t know how to avoid the risks of trading stocks. While it is true that microcap stocks are riskier than stocks from companies with much larger capitalizations, you can just as easily lose your investment in the NYSE if you don’t know how to manage your stock portfolio. Veteran traders of the OTCBB market will tell you that the microcap market is not a place to invest your life savings. It is not the place to turn your last few thousands of dollars into a fortune. Rather, the OTCBB market is a public space where you can invest smaller quantities of cash in a calculated manner with the intent to generate a profit. Before you invest anything into this market, you should have done plenty of research work and read more books to improve your grasp of how penny stocks can turn a profit for you. This part of the book will help you get ahead by providing you with tips from seasoned microcap warriors who continued focusing on microcap stocks regardless of the economic condition of the larger indices.


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Tip # 1: Analyze the Stock Market and the Big Indices Contrary to popular belief, OTCBB stocks are actually heavily influenced by the ups and downs of the larger indices used in the NYSE and other large stock markets. There is definitely a strong confluence between the penny stocks and regular company stocks from medium cap and large cap companies. What does this mean for the penny stock trader? A person who is engaged in penny stock trading should always be on the lookout for significant changes in the trends in larger indices such as the Dow Jones Industrial Average. When there is a downward trend in the big lists, you can be sure that this will affect not only the dollar volume of the OTCBB market but also the values of individual company stocks, even if these stocks have no direct relations with the company stocks in the larger market. Why are penny stocks affected by the big stock market? Penny stocks are vulnerable to changes in the big stock market because a large percentage of penny stock investors are also investing in medium cap and large cap stocks. When there is a downward trend in the stock market, investors will naturally want to liquidate stocks that present the highest risk to the overall health of a stock portfolio. Obviously, small cap stocks are the riskiest and so they will be liquidated first.


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Tip # 2: Strike When the Time is Right When is the best time to start buying stocks of a particular small cap company? There are actually no hard and fast rules when it comes to investing stocks. Shares of stock are financial instruments, after all, and what you do with them depends on your analysis of the present situation. Your decision to buy or sell stocks will affect the stock market if a large percentage of investors does the exact same thing. If you are relatively new to penny stocks and investing in the stock market, you should be conservative and cautious when buying new stocks. To ensure that your investment would be on steady ground, make sure that two conditions exist: The first ideal market condition is when the total dollar volume of the OTCBB market is up. This can be ascertained by checking past analyses and reports of the OTCBB market itself. If there is a continuous climb in the dollar volume this means that investors that are focused on DOW and NASDAQ are making huge profits and they’re pouring some of the money into the small cap market. This influx in dollar volume indicates that a potential upward trend is about to occur in the OTCBB market. The second ideal market condition occurs when the prices of robust stocks are relatively stable and you can start buying the ones that you want. If the dollar volume is increasing, that means that there are more people investing OTCBB stocks. Low stock prices means that there is no artificial inflation of stock prices (this was apparent just before the DOTCOM bust) and it’s safe to pour some of your own funds in OTCBB stocks.


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You have to be extremely careful when there is unprecedented dollar volume in the microcap market but the prices of stocks are sky high. Some people think that this is sustainable and that there are many small cap companies that are on the verge of a breakthrough. History teaches us otherwise! Again, looking at the DOTCOM bust of the nineties, we’ve learned the hard way that even if there are a lot of dollars flowing in and small cap companies are riding the wave of high stock prices and an influx of new investors, things can radically topple in a matter of weeks. This is a painful truth that both NASDAQ traders and OTCBB traders had to contend with when they failed to realize that the bubble was about to burst and everyone was still sipping champagne. Tip # 3: Practice with Pink Sheet Stocks I know that this might sound strange after I discussed the inherent risk associated with pink sheet stocks, but do hear me out: pink sheet stocks are by far the cheapest stocks in the OTCBB market. Regular microcap stocks typically cost $3-$5 per share of stock. Pink sheet stocks are literally worth just pennies each. The beauty of pink sheet stocks is that while they are inherently risky, they can be used by the budding investor as a real-world testing ground. If you’re trading stocks for the first time, you wouldn’t want to pour down thousands of dollars immediately. I recommend sticking to $1,000 maximum if you’re still not sure what you’re doing. I’ve met some budding investors who limited their capital investments to a few hundred dollars the first few months so that they won’t lose a ton of cash if their portfolio turned out to be bad.


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The single strongest advantage of pink sheet stocks is that their value can increase quite rapidly – if you happen to chance upon the upward crest! I’ve seen some pink sheet stocks go up 150% in a matter of days – that’s a sweet deal, indeed. However, as pink sheet stocks are rather dynamically unstable, the opposite can occur too. A pink sheet stock that seems to be the on verge of a complete breakthrough can suddenly lose its momentum and drop in value in a matter of weeks. You have to be careful about these sudden changes, as you will lose money. Another potential issue that first time traders should be aware of is the probability that they won’t be able to sell their pink sheet stocks fast enough if something goes wrong. There are some instances when there are no buyers and a trader is stuck with his pink sheet stocks that are rapidly losing their value. Tip # 4: Hard Research Pays Off In the world of penny stocks, working knowledge of “hot companies” can spell the difference between a bad investment and a momentous one. We all know that penny stocks are regarded in a negative light because some of these companies don’t report revenues and issue dividends regularly enough. This is a fact of life that we need to accept if you want to continue trading penny stocks. The only way that you can reasonably reduce the inherent risk associated with penny stocks is if you do hard research before investing a large sum of money on a particular small cap company. Now, there are instances when a small cap company begins issuing increasingly absurd numbers of shares – like millions or billions of shares. If a small cap company is not issuing financial reports


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regularly and it continues to issue shares of stocks, should you shy away from the penny stocks? The answer is: it depends on what you discover. The fact of the matter is that companies suffer from mounting debts and so whenever they do make a profit, they use the profit to pay off the interest of their debts. Profit is essentially cancelled out in the process. To continue sustaining company operation, a small cap operation may opt for share dilution, or the issuance of even more stocks at a lower price to ensure that more investors come in to help raise the necessary capital to keep moving forward. It’s quite difficult to say that a company is bad simply because it is attempting to pay off its debts so it won’t fold – and so we turn to hard research for answers. If a company is a global brand that is still distributing large quantities of goods and yet it’s not making any headway in the penny stock market, there’s a big chance that the small cap stock you’re looking at is actually promising because the tides of fortune can change any day. Tip # 5: Be Careful of OTCBB Message Boards and Forums In our day and age, people typically head to the World Wide Web when there is urgent need for information. The Internet is the cheapest and most accessible source of “tips and tricks” – which makes it a potentially problematic reference. This applies specially to OTCBB message boards and forums where budding investors flock for “hot stocks” and other stock-related tips. When I first started trading stocks, I also visited many message boards and stock trading forums because I wanted to be aware of


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what other people are focusing on at the moment. I discovered early on that message boards can be partially useful if you are selective about what you believe in and how you use the information. There are two things that you should be aware of when scouring OTCBB message boards and forums: 1. Spam Posts - Beware of individuals who incessantly post new threads on a daily basis using different accounts. I call these “stock bots” and they have nothing new or useful to offer. Many of them are simply looking for ways to sell snake oil to unsuspecting new traders. Beware new threads and stick to old threads with lots of views and responses as these are often better moderated and there are real people interacting in these threads. Forum ranking systems are actually better nowadays and if a forum is turning a profit from ads, you can be sure that there are active administrators watching what members and forum posters are doing. 2. Stock Bashing – “Stock bashing” is an extremely common practice in large stock trading boards. People engage in this practice to influence how people buy and sell specific company stocks. Stock bashing rarely influences medium-cap and large-cap companies. However, the scene is quite different when you’re talking about small-cap companies. Many small cap companies offer only a few thousand shares. If people simultaneously sell their stocks because of what they read on the message boards, the sudden sale of stocks could grievously harm the value of stocks.


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Of course, it’s up to the investors to analyze the stock bashing occurring in message boards. The bashing is not going to stop any time soon because it’s part of the online trading culture. As long as a person is not saying something that is outright libelous, he can continue insinuating that a company is folding in a matter of weeks. If a lot of people believe the rumors, investors just might act upon the “news.” Tip # 6: Don’t Act Hastily The OTCBB market is a bit different from the large stock market when it comes to filling stock orders. Bidding prices and asking prices represent the “war” between the market makers and the investors themselves. When the asking price increases due to a present trend, it’s possible that you are simply being tricked into paying more for a particular stock. Since penny stocks are cheap, you may be tempted to give in to the asking price just to get new stocks into your portfolio. Don’t let the market makers get their way with you! What experts usually do is that they allow their stock orders to remain open instead of giving in to inflated asking prices. Again, if there is no concrete trend that would potentially generate a profit for you, don’t press that “buy” button just yet!


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Chapter 4:

Surviving Rough Times


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How can you continue turning a profit even when times get rough? The stock market is often the first one to get hit hard during recessions and other economic downslides. Stock traders often fear for their money when times get rough and as a budding investor, you may feel hopeless when the penny stock market begins misbehaving and your portfolio becomes an increasingly losing proposition. Don’t worry: there are ways to outsmart harsh economic phases and still come out victorious when trading penny stocks and even regular stocks. Here are some tips from veteran traders as to how you can weather the storm so you can keep the cash flowing, even if other traders are selling their stocks for fear of massive losses: 1. Study Long Term Trends – If you want to invest a large chunk of your available cash in certain stocks, you can make a solid decision based on the long-term trend of these stocks. A stock is deemed healthy when the dollar volume being added to it is on an upward trend for months and the upward trend is maintained continuously before the next great increase occurs. If the peak dollar volume is often repeated over a period of weeks, there’s a good chance that a stock will be able to break through a peak position and climb once again. The lowest position of a stock should also be consistent; any large dips can spell trouble. This type of data will only make sense if you can look at the various trading positions of a stock over a period of at least six months. 2. Forget About Compulsive Trading – When a trader is about to lose money, he often engages in compulsive trading. Compulsive trading is actually more convenient nowadays because of the


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availability of instant electronic trading platforms where traders only have to press buttons to buy or sell stocks. This compulsive approach to stock trading will only result in more losses than actual long-term profit. If you are easily spooked by negative news then it would be best to avoid messaging boards as there is no shortage of such “information” in such places on the Internet. Study your positions and trade only if you think you’re entering a strong trend that will provide a good capital return. Otherwise, maintain your positions and continue your study of the overall market trend. It is only through restraint and cautiousness in trading that you will mature as a trader. 3. Dealing with Short-Term Fluctuations – One of the main reasons why many first time investors are burned out by electronic trading is the presence of market volatility and the endless short-term fluctuations that occur across the indices all year round. Many investors become exhausted and overwhelmed by all the tiny adjustments that they need to make just to avoid the effects of short-term fluctuations. To avoid being burned out, focus on long-term gains. If you are invested in stocks in relatively stable industries, there’s no reason to become duly focused on buying and selling stocks due to short-term fluctuations.

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