This is a continuation of what to look for in micro cap companies. To see the first article click here.
Because nano cap firms are small they lack liquidty. This creates several problems for investors. It is sometimes hard to buy shares (especially in large quantites) without paying a large premium. Similiary, often it is hard to sell because of the liquidity problems.
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Lack of liquidity, hampers a company’s ability to issue a secondary offering at a satisfactory price. Usually a company will have to resort to debt for its capital. The company might have to borrow from a bank at a very high interest. Worse, some banks wont lend at all and the company will reach out to private equity firms or other lenders who will lend on very unfavorable terms for the nano company.
For example there is a firm I was researching that seemed to be cheap, it had EBITDA of approximately $7 million and a market cap of $23 million. It sounds like a screaming buy. However, the company needed cash as it’s balance sheet was deteriorating. It was not generating enough cash to meet its needs. The company sold 5 million convertible preferred shares to a lender which charged them 18% interest per annum. The lender converted half the shares and was able to control over 60% of the company. The company now was completely subservient to the lender and had to pay astronomical interest fees to them. Let us just say this does not look like a happy ending for this firm.
A company like Exxon Mobil has a market cap of nearly $300 billion. It would be nearly impossible for the owners to own a large % of the company. I have seen nano cap companies where the CEO owns 50% of the company. This could be a good thing if the CEO is interested in creating shareholder value. However, more likely the CEO or other insiders are more interested in enriching themselves. They sometimes can do quite well even if the share price of the company suffers. Martin Whitman talks about this many times in his various books. An outside investor therefore has to be careful when investing in these situations.
Although dilution can be an issue with all companies, I find that in nano caps there tends to be more potential dilution. I was researching one firm that had 3.6 million shares outstanding. However, including options, convertible preferred and warrants there was a chance shares could increase by an additional 1.2 million. This would increase shares outstanding by 33%!! The lesson is it is always important to look at company fillings and look for possible dilution. A conservative investor should always assume that a possible dilution will occur.
Several Hundred Thousands of dollars Can Make a Difference:
In big companies millions of dollars are made or lost each day.When my brother in law was an auditor for a big financial firm anything under $5 million that could not be accounted for was considered immaterial. In a nano cap firm a few hundred thousand dollars can make the difference between a profitable company, and an insolvent one.
Revenue can change dramatically from small changes
A company I was researching, increased their revenue dramatically from 2008 to 2009. However, in one of the fillings I found a line that explained this large increase. The company made one sale of a large radar unit to the army worth about $1.5 million. Had it not been for this sale, year over year revenues would have been flat. In a large company a one time big sale of a unit could make a large difference in revenue and y earnings per share, but it rarely has this large of an impact.
Litigation could be costly
While litigation is always costly for a companies, for nano cap companies it can be disasterous. If a company is sued they will have to pay thousands if not millions of dollars in legal fees. This relates to an earlier point I made. A few hundred thousand dollars could make a huge difference for a nano cap company. For example if a nano cap company is earning $1 million a year and has a market cap of $10 million the company might be considered cheap. However, if there is a lawsuit this could wipe out the entire profit for the year.
Investors Are Looking at Micro Companies
There is a common belief that there are more opportunities in the nano cap world because there is little analyst coverage. While this is true investors must be careful with this fact. While analysts are not looking at the company, many other investors might be. For example a distressed nano cap company with a market cap under $20 million was in need of capital. The firm I am at was in discussions with the CEO about a possible capital injection. The CEO stated that he currently had offers from four other firms . While the CEO may have been lying, the lesson is that there are other good investors looking for opportunities in even the smallest of companies. I found a company with a market cap of $10 million in which Mario Gabelli owned 20% of shares outstanding. This is a man who manages billions of dollars investing in some unknown company, that on most days does not even trade.