ing at below $1 per share. They arespeculative securities of very small companies. By definition, allpenny  stocks  trade  in  the  OTC  Bulletin  Board  (OTCBB)  or  thepink sheets, but do not trade on national exchanges such as theNew York Stock Exchange or the Nasdaq Stock Market.
The  OTCBB  is  an  electronic  quotation  system  that  displaysreal-time  quotes,  last-sale  prices,  and  volume  information  formany OTC securities that are not listed on the Nasdaq Stock Mar-ket or a national securities exchange. Brokerage firms subscribeto the system and can use the OTCBB to look up prices or enterquotes for OTC securities. Although the National Association ofSecurities  Dealers  (NASD)  oversees  the  OTCBB,  the  OTCBB  isnot part of the Nasdaq Stock Market. Unscrupulous stockbrokers
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will often claim that an OTCBB company is a Nasdaq company tomislead  investors  into  thinking  that  a  company  is  really  biggerthan it is.
The  pink  sheets  are  named  for  the  color  of  paper  on  whichthese stock quotes are printed. They are listings of price quotesfor companies that trade on the over-the-counter (OTC) market.OTC market makers are the brokers who commit to buying andselling the securities of OTC issuers. They use the pink sheets topublish bid and ask prices for companies of which they may wantto buy and sell shares. A company named Pink Sheets LLC, for-merly  known  as  the  National  Quotation  Bureau,  publishes  thepink sheets in both hard copy and electronic format. Pink SheetsLLC is not registered with the Securities and Exchange Commis-sion as a stock exchange, nor does the SEC regulate its activities.The structure and use of penny stock issues is discussed in moredetail in Chapter 12.
It is important to understand that the share price of a stockhas no bearing on or relationship to market cap. A perfect exam-ple of this is Nortel Networks, with a share price of $2.70 as ofJune 30, 2003. Nortel is not a micro cap stock or a penny stock.With 3.85 billion (yes, billion!) shares outstanding, Nortel sports amarket cap of $10.4 billion ($2.70 share price × 3.85 billion sharesoutstanding  = $10.4  billion  market  cap).  Nortel  Networks  is  alarge  cap  stock.  (See  Figure  1.2.)  Conversely,  Seaboard  is  anagribusiness  company  listed  on  the  American  Stock  Exchangethat currently trades at $207 per share. With 1.255 million sharesoutstanding, the company has a market cap of $260 million ($207share  price  × 1.255  million  shares  = $260  million  market  cap).With  a  share  price  of  $207  per  share,  this  is  a  micro  cap  stock.Thus, small companies can have big share prices and big compa-nies can have small share prices. Share price in general is has nodirect relation to the size of a company.
In fact, share price has no relationship to the size of a busi-ness. Consider the Internet boom for a moment. There were manymulti-billion-dollar market cap companies that had no revenues,few employees, and limited tangible assets. In many ways, marketcap  reflects  the  consensus  of  investor  opinion  about  the  futureprospects for a company.
The classic case study of this phenomenon is that of Amazon
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9
FIGURE 1.2 Nortel Networks price chart.
.com and Barnes & Noble. In May 1997, Amazon went public witha  market  cap  of  about  $400  million.  By  January  1999,  the  shareprice had reached about $100 and the market cap was $38 billion,as compared to Barnes & Noble, the nation’s largest bookseller,with  a  market  cap  at  the  time  of  around  $2.6  billion.  In  1998,Barnes & Noble had revenues of $3 billion and earnings of $1.29per  share,  while  Amazon  had  revenues  of  $610  million  and  lost$.42 per share. Yet with sales one-fourth those of Barnes & Noble,and considering that it was losing money versus turning a profitof $1.29 per share, Amazon commanded a market value 14 timesthat of Barnes & Noble. And Amazon started out as a micro capopportunity. (See Figure 1.3.)
Amazon is now widely held in institutional investment portfo-lios. At the time of its initial public offering (IPO), it is unlikelythat many institutional investors owned the company. The beliefwas  that  individual  investors  were  primarily  willing  to  supportearly-stage industries such as computer companies and the Inter-net. This was the main driver behind micro cap stocks. However,few  institutional  investors  would  consider  micro  cap  issues as viable investments because, in many instances, the business
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FIGURE 1.3 Amazon.com price chart.
models and technologies were largely unproven. It was only whenthe  companies  became  large  enough  that  institutional  investorswould consider the possibility of investing in them.
Each year hundreds of these small, undiscovered companiesgrow to become hot small cap opportunities as they emerge fromthe micro cap universe. When these small companies reach $500million to $700 million dollars in market capitalization, they typi-cally become the focus of small cap research analysts and smallcap investment management companies that are actively seekingemerging opportunities from the micro cap segment. This leavesthousands of stocks to go virtually unnoticed by the professionalinvestment community until they graduate into the ranks of thesmall cap and beyond.
In the year ended June 30, 2004, 554 companies graduated fromthe micro cap to the small cap arena simply due to price apprecia-tion. In fact, the average 12-month return of the graduating classwas 113 percent. During that same year, 651 companies descendedfrom  the  ranks  above  micro  cap  into  the  micro  cap  arena  whentheir market capitalization shrank to below $500 million.
At  the  end  of  March  2003,  American  Airlines  had  a  marketcapitalization  of  around  $300  million.  As  of  June  30,  2004,  the
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stock  closed  at  $12.  American  Airlines  existed  as  a  micro  capbecause of a change in the dynamics of the airline industry as aresult of the attack of September 11, 2001. Just as the consensusof  investor  opinion  reflected  a  positive  outlook  for  Amazon,  asimilar consensus of investor opinion had a very negative outlookfor American Airlines. It is these very extremes in investor emo-tion that often create opportunity. And it is these extremes thatare often reflected at some point within the micro cap segment.However, to better understand these extremes, an investor mustunderstand  the  information  advantage.  Chapter  2  will  examinethe concept of the information advantage.
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CHAPTER 2
The InformationAdvantage
This chapter will attempt to answer the following questions:
• Is  there  a  possible  information  advantage  for  diligent  micro
cap investors?
• How can this information advantage be explained in the con-
text of efficient market theory?
UNDERSTANDING THE INFORMATION ADVANTAGE: EFFICIENT MARKET THEORY
The information advantage is the reason that opportunity existswithin  the  micro  cap  arena.  However,  an  understanding  of  theconcept of the efficient market theory (EMT) is required to under-stand  the  information  advantage.  Efficient  capital  markets  andthe  efficient  capital  market  group  of  theories  have  importantimplications for micro cap investors as well as for security valua-tion. The definition of an efficient capital market is relatively sim-ple.  However,  it  is  less  frequently  asked  why  capital  marketsshould be efficient.
The  basis  for  EMT  is  premised  on  certain  conditions  thatmarket participants assume exist when examining capital market
13
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opportunities.  The  first  premise  of  an  efficient  market  is  thatthere  are  a  large  number  of  profit-maximizing  investors  con-cerned with the analysis of information related to the investmentopportunities  within  a  market.  And  it  is  further  assumed  thatthese  participants  operate  relatively  independently  of  oneanother. A second assumption about efficient markets is that newinformation  about  securities  arrives  to  the  market  in  a  randomfashion. In addition, the announcement of this information is gen-erally independent of other new announcements over time. Thethird assumption of an efficient market is particularly importantin  the  micro  cap  arena.  This  condition  assumes  investors  willadjust  the  market  price  of  securities  quickly  to  reflect  the  per-ceived effect of new information in the market. But it is generallyagreed that at times when price adjustments are reflected in themarket, they are not always perfect. It is not unusual to see over-reactions or underreactions to new market information. Marketscan be very emotional over the short run. But it is often difficultto anticipate and identify these market reactions.
The idea that the market attempts to adjust securities pricesquickly is based on the first premise that there are a large numberof profit-maximizing investors attempting to reflect that informa-tion  in  the  value  of  a  stock  price.  When  the  effects  of  randominformation coming to the market in an independent fashion arecoupled with the presumed large number of investors adjustingstock prices rapidly to reflect new information, it is assumed thatprice changes are independent and random.
Therefore, the crucial point of the efficient market discussionis  that  the  adjustment  process  requires  a  large  number  of  in-vestors  who  follow  the  stock  and  analyze  the  impact  of  newinformation  on  the  stock.  That  group  of  investors  then  buys  orsells the stock to adjust the price to reflect the new informationavailable in the market. It is at this point in the theory where apotential  information  advantage  begins  to  develop  within  themicro  cap  sector.  The  general  academic  conclusion  about  effi-cient  markets  is  that  securities  prices  at  any  particular  point  intime  will  reflect  an  unbiased  outlook  of  all  currently  availableinformation in the market. So an efficient market is one in whichsecurities prices adjust rapidly to the delivery of new informationand  current  stock  prices  fully  reflect  all  available  informationincluding the future risk involved in the security price.
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The early analysis of the efficient market concept was oftencalled  the  random  walk  hypothesis. A  pivotal  study  thatattempted  to  organize  a  large  amount  of  information  about  therandom walk theory was done by Eugene Fama in a Journal ofFinance article entitled “Efficient Capital Markets: A Review ofTheory and Empirical Work,” which was published in May 1970.Fama’s article presented the efficient market theory in terms of afair game model.
Unlike work done under the random walk hypothesis, the fairgame model deals with price at a specified period. It assumes thatthe  price  of  a  security  fully  reflects  all  available  information  atthat period. The model requires that the price formation processbe specified in enough detail so it is possible to indicate what ismeant by “fully reflected.” Fama’s analysis went on to divide theefficient  market  hypothesis  and  empirical  tests  into  three  cate-gories depending on the information set involved. His theory saidthat EMT comes in various strengths, depending on what infor-mation is, by theory, assumed to be reflected in the stock price.
Weak-Form Efficient Market Theory
The  weak-form  EMT  maintains  that  all  information  about  pastmarket  prices  is  already  reflected  in  the  stock  price.  The  weakform assumes not only that current stock prices fully reflect allstock  market  information  but  that  they  include  the  historicalsequence of prices, price changes, trading volume, and any othermarket-related  information  that  is  publicly  available.  Becausecurrent price should reflect all past price changes and any otherstock  market  information,  this  hypothesis  implies  that  thereshould be no relationship between past price changes and futureprice changes. Thus, the famous disclaimer: “Past performance isno  indication  of  future  results.”  The  theory  concludes  that  anyanalysis that depends on past price changes or past market datato predict future price changes or future market data should havelittle value in terms of investment contribution. The implicationof this is that all of the rules of charting and technical analysis,which focus on past price and volume changes, are entirely use-less. This is the conclusion in spite of the fact that many large WallStreet firms employ one or more full-time technical analysts ontheir staff.
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Semi-Strong-Form Efficient Market Theory
The  semi-strong-form  EMT  maintains  that  all  publicly  availableinformation  about  a  company  is  already  reflected  in  its  stockprice. It asserts that securities prices adjust rapidly to reflect therelease of all new public information. The semi-strong hypothesisincludes  the  weak-form  hypothesis  because  all  public  informa-tion,  including  all  market  information  such  as  stock  prices  andtrading volume and all nonmarket information such as earningsand  stock  splits,  would  be  fully  reflected  in  share  values.  Thedirect implication of the semi-strong hypothesis is that investorswho  act  on  important  new  information  after  it  is  public  cannotobtain market-beating profits from the transaction. In theory thisis because the security price already reflects the effect of the newpublic information. A consequence of this version of EMT is thatthe analysis of earnings, corporate filings, press releases, interestrate changes, and other fundamental data analysis are essentiallyuseless.  This  should  give  cause  to  the  elimination  of  stockresearch that is earnings focused.
Strong-Form Efficient Market Theory
The strong-form EMT maintains that stock prices fully reflect allinformation, both public and private. It implies that no group ofinvestors has access to information relative to the formation ofprices that would be of advantage to them over other investors.Therefore,  no  group  of  investors  should  be  able  to  consistentlyderive  above-average  profits  from  the  market.  The  strong-formhypothesis  includes  both  the  weak  and  the  semi-strong  forms.The strong form requires not only efficient markets where pricesadjust  rapidly  to  the  release  of  new  information,  but  it  alsorequires  perfect  information  markets  where  all  information  isavailable to everyone at the same time. This form of the efficientmarket theory contends that because all information is immedi-ately available to everyone and rapidly discounted by everyone,no  group  has  meaningful  access  to  important  new  informationand therefore nobody can derive above-market profits over longperiods of time. The implication of this form of EMT is that indus-try analysis and even inside information are useless.
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It was probably the strong-form EMT that gave rise to the oldjoke about the two efficient market theorists that is told in everygraduate business school capital markets class. It goes like this:There are two efficient market theorists walking down the street,when they see a $100 bill on the ground. Looking at each other,they precede to walk right by it, neither making any effort to pickup the cash. Why? Because as efficient market theorists, they con-clude that if the $100 bill were real, it would have been picked upalready.
The Random Walk Theory
There is another flavor of the EMT, known as the random walktheory. This concept was first put forward by Burton Malkiel inhis book A Random Walk Down Wall Street (New York: W.W. Nor-ton, 1990), in which he challenges the idea that stock prices canbe  predicted.  He  essentially  concludes  that  no  market  strategycan consistently outperform a buy-and-hold index approach.
The basic principle of the random walk is that there is no suchthing as a free lunch. The opportunity to get something for noth-ing  is  not  available  to  investors.  The  $100  bill  that  the  EMTswalked by would never be lying there. This is because the stockmarket is a very efficient mechanism in the long run. It reflects anongoing battle among many intelligent active investors who pro-vide strong competition to any and all market participants. Com-petition ensures that there are no quick and easy profits and thatoutsmarting  the  market  is  exceedingly  difficult.  Other  partici-pants in the market are just as sharp and aggressive, and they arenot about to allow someone else to make a profit if they can makeit themselves.
The result of this competition inside the stock market ensuresthat transactions take place at a competitive price and that thoseprices reflect a clearing level that both the buyer and the sellerdeem  reasonable.  Said  another  way,  the  buyers  buy  because  asbuyers they believe the stock is undervalued or, at worst, fairlypriced. In theory, once the buyers become the owners, they wouldnever  sell  a  stock  if  they  believed  the  stock  was  too  cheap  orundervalued. Sellers, however, would sell a stock that they con-sidered  overpriced  to  buyers  who  believed  they  were  getting  a
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bargain. And on average, you could say that both the buyers andthe  sellers  were  equally  correct.  Their  competitive  positionsresult in a general standoff with the vast majority of stock markettransactions  taking  place  at  what  the  broad  consensus  of  thou-sands  of  shareholders  would  consider  fair  prices.  The  compe-tition  between  millions  of  active  buyers  and  sellers,  with  allinvestors  trying  to  make  a  return  on  their  investment  that  ishigher  than  that  of  the  market,  suggests  that  stock  prices  fairlyreflect  the  future  returns  from  holding  a  particular  stock.  This,Malkiel  concludes,  suggests  there  is  no  way  to  tell  which  stockwill provide superior returns that has not already been imaginedby other investors. Thus, there is no way to predict which stockwill go up and which stock will go down on any particular day.The theory would hold that one stock has just as good a chance asany other stock.
But stock prices do change on a daily basis. Some prices areup each day, while others are down. Because competition in themarketplace  implies  that  investors  cannot  anticipate  thesechanges,  the  changes  must  essentially  be  random.  It  is  as  ifsomeone were flipping a coin in an attempt to decide whether astock price will go up or down. And tomorrow the coin is flippedagain, and the following day it is flipped again. As a result, stockprices  wander  up  and  down  randomly  in  irregular  and  unpre-dictable patterns in a manner that is typically called a “randomwalk.”
Efficient  market  theorists  of  all  disciplines  would  concludethat beating the market over a long period of time is not possible.The weak-form EMT suggests that technical analysis or price pat-tern observations cannot work. The semi-strong EMT eliminatesthe possibility that fundamental analysis can help an investor out-perform  the  market.  And  the  strong-form  EMT  concludes  thateven  material  inside  information  will  not  provide  an  advantageover the long term. The random walk theory concludes that thecontinuing  battle  between  buyers  and  sellers  precludes  anyonefrom  picking  stocks  as  a  group  that  will  outperform  an  index.Index-like  performance  is  the  best  an  investor  can  hope  toachieve  in  terms  of  investment  performance,  according  to  theefficient market theorist. And the most efficient way to achievethat performance is to invest in index funds or index shares.
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The Practical Answer
A review of the academic literature will show that there are vari-ous research studies that both support and call into question eachsegment of the EMT as put forth by Fama. There is a similar groupof  studies  that  question  numerous  aspects  of  the  random  walktheory as put forth by Malkiel. More important to this discussionis  the  fact  that  there  is  a  small  but  growing  body  of  academicresearch  suggesting  that  some  aspects  of  the  efficient  markettheory can be questioned when looking at smaller and very smallstocks.
At this point, a rigorous review and analysis of the mathemat-ical foundation of each form of the efficient market theory mighthelp  show  the  weakness  in  EMT.  However,  for  the  purposes  ofthis book it is more meaningful to ask some straightforward ques-tions about the general concept of the efficient market theory andexamine the probable answers to those questions. The questionsare simple:
• Why  do  some  actively  managed  funds  beat  the  market  over
long periods of time?
• Why, at times, do whole companies sell for less than the mar-
ket value of the net cash on the balance sheet?
• Why do small capitalization stocks outperform large capital-
ization stocks over time?
• Why have stock prices generally gone up over time?• Why  do  most  micro  cap  managers  outperform  their  bench-
marks?
In  an  interesting  analysis  in  the  Journal  of  Financial  Man-agement (“A Cross Sectional Approach to Market Liquidity,” May1982), Frank Riley suggests that the market can be divided intothree  different  tiers.  The  top  tier  contains  companies  largeenough  to  accommodate  all  institutional  investors  who  wish  totake a meaningful position and retain liquidity. A middle tier con-sists of companies that are large enough to be acquired by mostinstitutional investors and large investors, although they are prob-ably  too  small  to  be  of  interest  to  the  top  100  institutionalinvestors. And then there is a bottom tier of companies that are
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not large enough to be considered by most institutional investors.The study estimates that the total number of public companies inthis  bottom  tier  at  any  given  time  is  between  5,000  and  8,000.Riley  concludes  that  analysts  should  be  encouraged  to  concen-trate their efforts on middle-tier firms because these stocks con-tain the characteristics to ascend to the top tier of the market, butthey do not receive the attention given to top-tier stocks. So themarket  may  not  be  as  efficient  in  reflecting  all  the  informationabout these middle-tier stocks.
Riley concludes that if there is a difference in the number ofanalysts following a stock, one could conceivably argue a differ-ence in efficiency of the information reflected in the stock’s value.In the case of a top-tier stock, all new information regarding thestock  would  be  well  publicized  and  numerous  analysts  wouldevaluate  the  effect.  News  about  middle-tier  firms  is  not  as  wellpublicized,  and  fewer  analysts  following  these  firms  would  bereflecting  their  opinions  about  the  impact  of  the  news.  Thus,prices may not adjust as rapidly to new information, and there-fore concentrating on those middle-tier stocks could conceivablyadd value over long periods of time. After the Riley study, a num-ber of additional studies came out that indicate superior returnprofiles  for  stocks  that  are  followed  by  fewer  analysts.  As  dis-cussed in Chapter 1, most micro cap stocks have few if any ana-lysts following them. Furthermore, the quality of the analysis isoften lower than that of the analysis on larger capitalization secu-rities.
It’s fair to conclude that information concerning larger stocks,which  are  more  widely  held  by  institutional  investors,  wouldmore  rapidly  reflect  changes  in  information  available  about  thesecurities due to the high levels of scrutiny and analysis that arefocused on those securities. It is unlikely that there is any infor-mation, public or private, that an individual investor can discernabout  a  giant  company,  such  as  Microsoft,  that  the  institutionsand legions of analysts who cover Microsoft don’t already know.Conversely,  it  would  then  be  safe  to  assume  that  securitieswith little or no coverage by institutional investors and a low per-centage of institutional ownership would require a longer periodof time for all publicly available information to be fully reflectedin the share price. It seems possible that a diligent individual orinstitutional  investor  could  discover  some  level  of  pertinent
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information not reflected in the share price of a small companythat  is  not  adequately  researched  by  investment  analysts  andinstitutions.
VENTURE CAPITAL THEORY
No single theory of market performance seems to address all theissues  with  regard  to  the  efficient  market  theory;  however,  it  isgenerally agreed that over long periods of time the markets tendto reflect all available information and are relatively efficient inthe reflection of that information in terms of securities value. It isalso agreed that over shorter periods of time this information maynot be fully reflected in the market valuation of common stocksor that markets may overreact to information. It is that short-termrelative inefficiency that allows for a potential information advan-tage to the micro cap investor.
There are some simple statistical data that might further sup-port the idea that there is an information advantage available tomicro cap investors. First, it is known that over long periods oftime,  stock  market  prices  tend  to  go  higher  in  the  aggregate  toreflect the economic growth in the underlying economy. Second,we  also  know  that  smaller  capitalization  stocks  provide  largerreturns than big capitalization stocks over those same long peri-ods of time. From these two simple facts, when considered withinthe framework of the efficient market theory, it would be possibleto conclude that smaller stocks are less efficient in reflecting allavailable information in the market, and although they reflect thatinformation  over  time,  managers  of  small  and  micro  capitaliza-tion stock indexes have the opportunity to use that informationadvantage in producing higher returns.
As stocks become larger and are more widely held by institu-tions and more fully studied by investors, it becomes increasinglydifficult to gain a similar information advantage. Large capitaliza-tion stock prices, in theory, will react more quickly to availablemarket information, therefore making it more difficult to capital-ize on the information advantage. Discovering and capturing thisinformation advantage is the key to achieving investment perfor-mance in the micro cap arena.
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No single market theory alone explains the unique investmentcharacteristics  of  the  micro  cap  sector.  The  empirical  data  sug-gest that the micro cap sector is less efficient in the short termthan larger capitalization sectors of the market. As we have dis-cussed, there are a number of market theories that may help topartly  explain  this  phenomenon,  but  no  single  “unified  theory”exists. However, when certain elements of venture capital theoryare added to the existing data, a more unified theory that couldreasonably explain the information advantage emerges.
The Public-Private Bridge
There is a large body of academic literature on the principal agentproblem  in  private  venture  capital  transactions.  This  literaturefocuses  on  the  conflict  of  interest  between  an  agent  who  is  anentrepreneur  needing  financing  and  a  principal  who  is  theinvestor providing the funds for the venture. The theory has iden-tified a number of ways in which the investor or principal can mit-igate these conflicts. First, the investor can engage in informationcollection before deciding whether to invest, in order to screenout  unprofitable  projects  or  bad  entrepreneurs.  Second,  theinvestor  can  engage  in  information  collection  and  monitoringonce the project is under way. Third, the allocation of cash flowbetween  the  entrepreneur  and  the  investor  can  be  designed  toprovide  incentives  for  the  entrepreneur  to  behave  profitably.  Inthese  three 