 increase  in  the  amount  of  securities  outstanding  if  it
exceeds 5 percent of the securities class outstanding
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THE MICRO CAP INVESTOR
7. Default on any senior securities or debt obligations not cov-ered within 30 days and affecting more than 5 percent of thecompany’s assets
8. A  decrease  in  the  amount  of  securities  outstanding  thatexceeds  5  percent  of  the  total  amount  of  securities  out-standing
9. Options  issued  to  purchase  securities  if  the  total  amount
exceeds 5 percent of the securities outstanding
10. The submission of any matters to a vote of shareholders11. Any material extraordinary charges or credits related to anyunusual  material  events  including  provisions  for  losses  andany  restatements  of  the  capital  or  shareholders’  equityaccount
12. A voluntary or involuntary change in the company’s auditors13. Any important event that the company believes to be material
to its operations
14. Any  changes  or  amendments  in  financial  statements  andexhibits  that  would  support  a  previously  filed  corporatereport, 10-K, or 10-Q
The key item to remember is that these SEC reports consti-tute an excellent source of information for an initial review of amicro  cap  company.  After  reviewing  these  forms,  it  is  easy  todecide  whether  you  want  to  move  on  to  secondary  sources  ofinvestment  information  as  described  or  if  in  general  you  havedetermined  that  the  company  would  be  of  further  interest.  It  isimportant to become familiar with these basic SEC reports andreview them as a part of your due diligence process when lookingat any new potential micro cap investment.
NOT ALL REPORTING IS EQUAL
Many micro cap stocks trade in the over-the-counter market andare quoted on OTC systems, such as the OTC Bulletin Board orthe  pink  sheets.  The  OTCBB  is  an  electronic  quotation  sys-tem  that  displays  real-time  quotes,  last-sale  prices,  and  volume
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Corporate Governance
79
information  for  many  OTC  securities  that  are  not  listed  on  theNasdaq Stock Market or a national securities exchange. Brokerswho subscribe to the system can use the OTCBB to look up pricesor  enter  quotes  for  OTC  securities.  The  NASD  oversees  theOTCBB, but the OTCBB is not part of the Nasdaq Stock Market.
The  pink  sheets  are  named  for  the  color  of  paper  on  whichthey  used  to  be  printed.  The  pink  sheets  are  not  printed  anylonger,  but  rather  are  listings  of  price  quotes  for  companies that  trade  in  the  OTC  market,  published  on  the  Internet  atpinksheets.com. Market makers are the brokers who commit tobuying and selling the securities of OTC issuers. They can use theelectronic pink sheets to publish bid and ask prices for micro capstocks. A company named Pink Sheets LLC, formerly known asthe National Quotation Bureau, publishes the pink sheets in bothhard copy and electronic format.
As  discussed,  the  biggest  difference  between  a  micro  capstock  and  other  stocks  is  the  amount  of  reliable,  publicly  avail-able  research  about  the  company.  Larger  public  companies  filereports with the SEC that any investor can get for free from theSEC’s  web  site.  Professional  stock  analysts  regularly  researchand write about larger public companies, and it’s easy to get thecurrent  stock  prices.  In  contrast,  information  about  micro  capcompanies  can  be  difficult  to  find  due  to  lower  reporting  stan-dards that result from the companies’ micro cap size.
Companies that trade their stocks on major exchanges and inthe Nasdaq Stock Market must meet minimum listing standards.For example, they must have minimum amounts of net assets andminimum  numbers  of  shareholders.  In  contrast,  companies  onthe OTCBB or the pink sheets do not have to meet any minimumstandards. Federal securities laws require all but the smallest ofpublic  companies  to  file  reports  with  the  SEC.  A  company  canbecome  public  in  one  of  two  ways:  by  issuing  securities  in  anoffering or transaction that is registered with the SEC or by regis-tering the company and its outstanding securities with the SEC.Both types of registration trigger ongoing reporting obligations,meaning  the  company  must  file  periodic  reports  that  discloseimportant  information  to  investors  about  its  business,  financialcondition, and management.
This  information  is  the  first  and  best  stop  for  micro  capinvestors. A public company must file reports with the SEC if it
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has 500 or more investors and $10 million or more in assets, or ifit lists its securities on the following stock markets:
• American Stock Exchange• Boston Stock Exchange• Chicago Stock Exchange• Cincinnati Stock Exchange• Nasdaq Stock Market• New York Stock Exchange• Pacific Exchange• Philadelphia Stock Exchange
In January 1999, the SEC approved an NASD rule allowing theNASD to require that all OTCBB companies file updated financialreports with the SEC or with their banking or insurance regula-tors. Beginning in June 2000, the rule applied to all companies onthe OTCBB. Since then, any companies who have refused to filetimely reports with the SEC or their banking or insurance regula-tors  have  been  removed  from  the  OTCBB  or,  in  essence,  aredelisted from trading until the reports are filed.
When an OTCBB company fails to file its reports on time, theNASD adds a fifth letter “E” to its four-letter stock symbol. Thecompany then has 30 days to file with the SEC or 60 days to filewith its banking or insurance regulator. If it’s still delinquent afterthe grace period, the company will be removed from the OTCBB.A  list  of  securities  that  have  been  removed  from  the  OTCBB  isavailable on the Internet at www.otcbb.com.
With few exceptions, companies that file reports with the SECmust  do  so  electronically  using  the  SEC’s  EDGAR  system.EDGAR stands for “Electronic Data Gathering and Retrieval.” TheEDGAR  database  is  available  on  the  SEC’s  web  site  at  www.sec.gov.  You  will  find  all  corporate  filings  in  the  EDGAR  data-base,  including  annual  and  quarterly  reports  and  registrationstatements. Any investor can access and download this informa-tion for free from the SEC’s web site.
Smaller public companies with less than $10 million in assetsgenerally  do  not  have  to  file  reports  with  the  SEC.  But  somesmaller companies, including micro cap companies, may choosevoluntarily to register their securities with the SEC. As previouslydescribed,  companies  that  register  with  the  SEC  must  also  filequarterly, annual, and other reports.
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CHAPTER 7
Micro CapStocks and theU.S. DomesticEconomy
This chapter will attempt to answer the following questions:
• Why  are  micro  cap  stocks  more  sensitive  to  the  domestic
economy?
• How do micro cap stock valuations compare to larger capital-
ization stocks?
An  important  characteristic  of  micro  cap  companies  is  the  factthat  they  have  relatively  lower  exposure  than  their  big  capbrethren to shifts in foreign economies. Sales of micro cap com-panies from foreign operations and exports account for on aver-age  approximately  18  percent  of  the  total  sales  for  micro  capcompanies. This compares with 35 percent of total sales from for-eign and export sources for S&P companies. In addition, about 24percent  of  micro  cap  companies  report  any  foreign  or  exportsales, whereas 69 percent of S&P companies report foreign sales.The exposure to foreign markets can create a completely newdynamic within a company. Of course, the opportunity for growthin foreign markets can be substantial, but there is also a consider-able risk involved in creating and running foreign operations. Themost  significant  financial  risk  from  foreign  operations  is  thatresulting from foreign currency exchange exposure. The transla-tion of revenues from a foreign currency into U.S. dollars can have
81
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a negative impact on earnings, even though the foreign operationmay be growing successfully. The variability of foreign exchangerates  can  cause  large  swings  in  a  company’s  earnings,  or  theattempt to hedge foreign currency exposure can cause derivativefinancial product risk on the balance sheet. A rising dollar trans-lates into lower earnings for a foreign operation; however, a for-eign currency rising relative to the dollar can create an earningswindfall,  boosting  operating  earnings  of  a  company  doing  busi-ness in that rising currency. As mentioned, currency exposure canbe hedged away on a short-term basis through the use of optionsand  derivative  currency  swaps,  and  many  large  companies  usecurrency hedging to smooth out foreign exchange exposure on anongoing  basis.  However,  it  is  important  to  note  that  there  is  anexpense to hedging foreign exchange and that frictional cost canresult in lower operating efficiency despite the currency hedging.A  strong  and  rising  dollar  can  also  put  pricing  pressure  onU.S. companies. The relatively low exposure of micro cap compa-nies to foreign markets can help reduce the risk of a strong andrising U.S. dollar. In addition, a falling dollar will have relativelylittle effect on most operations because they will not gain any for-eign advantage as a result.
Beyond financial exposure, foreign operations can carry withthem the political risk associated with operating in foreign coun-tries. In many instances, the opportunity for companies to createand maintain foreign operations is most pronounced in developingand third-world countries. These very countries, while providing thelargest opportunity, also create the largest potential political risk, asforeign governments and their policies can change dramatically invery short time periods. Companies with foreign operations, partic-ularly those in emerging and third-world countries, must be con-cerned with the political and legal changes within those venues, andinvestors should also be very mindful of the political risks involved.
WHY MICRO CAP STOCKS APPEAR CHEAP RELATIVE TO LARGE STOCKS
Micro cap companies, particularly fast-growing micro cap com-panies, often have financial requirements that are different from
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Micro Cap Stocks and the U.S. Domestic Economy
83
those of larger companies in mature industries with establishedproduct lines. These differences can lead to some striking valua-tion differences between the financial ratios of micro cap stocksand  those  of  their  larger-company  brethren.  It  is  often  mostnotable in the dividend policies of small versus large companies.Micro cap companies in general pay little or no dividends. It isestimated that only 26 percent of micro cap companies currentlypay a dividend, compared with 88 percent of S&P 500 companies.In fact, dividends are even more prevalent among small cap com-panies as defined by the Russell 2000, where 49 percent of com-panies  currently  pay  a  dividend.  In  addition,  the  average  yieldamong micro cap stocks is much smaller than the average yieldamong S&P stocks. For example, it is estimated that the averageyield among micro cap stocks is currently 0.6 percent, while thecurrent  yield  among  S&P  stocks  is  currently  1.4  percent—andthat is compared during a period in which we see the S&P 500 cur-rent dividend yield being near all-time historical lows and valua-tions being at or near all-time historical highs, yet valuations stillappear lower and dividends are currently higher than in the microcap universe.
A closer examination of valuations within the micro cap uni-verse will show that micro cap valuations tend to be clustered inone of two modes. There will be a group of micro cap stocks thattrade  at  valuations  that  are  significantly  higher  than  the  valua-tions of even the most expensive larger companies, and there willbe a group of micro cap stocks that trade at valuations that aresignificantly lower than the aggregate valuations of their large caprelatives. The micro cap stocks that carry large relative valuationsare  typically  early-stage  development  companies  that  have  notyet  realized  their  full  earnings  potential.  These  development-stage  micro  cap  companies  are  often  surrounded  with  greatpromise, and valuations can be surprisingly high given the modestfinancial position of many of these small companies. The PozenCompany case study discussed in Chapter 11 is an example of adevelopment-stage  micro  cap  company.  As  a  result,  the  trailingprice-to-earnings (P/E) valuations on these companies are usuallymuch  higher  than  the  forward-looking  P/E  valuations  of  theexpected future earnings.
Conversely, micro cap companies that either have fallen outof  favor  or  are  not  in  popular  market  sectors  but  rather  in 
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THE MICRO CAP INVESTOR
mundane  businesses  typically  carry  a  lower  valuation.  Theseapparently cheap companies often have generated positive earn-ings  over  many  years  and  in  addition  often  create  excellent positive cash flow. In many instances, these are truly value com-panies that can be bought at a significant discount in comparisonto larger companies in similar businesses. As discussed earlier,many of these companies have little or no Wall Street coverageand  have  been  overlooked  by  institutional  investors  because  oftheir size. It’s interesting to note that this bimodal distribution ofvaluation  leaves  very  few  companies  in  the  average  valuationrange.  It  is  important  to  understand  this  valuation  distributionand to note the valuation disparity in the micro cap world. Thereare opportunities to be found in both these valuation pools. (SeeFigure 7.1.)
FIGURE 7.1 As can be seen in this scattergram, although the return profileslook relatively close, valuation as measured by average P/E is normally muchlower for micro caps than for the Russell 2000 small cap index. The disparityonly becomes larger as market capitalization increases.
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Industry Analysis: Russell 2000 versus MicrocapsMarket Cap Weighted AveragesSIC Code Classification
Totals:
Russell 2000Microcaps
P/E 5-Year Average22.7117.43
INDUSTRY SUMMARY
Russell 2000 versus Microcaps
Industry
ADVERTISING
AEROSPACE/DEFENSE
AGRICULTURAL PRODUCT
AIRFRGHT & LOGISTICS
AIRLINES
ALUMINUM
APPAREL & ACCESSORY
APPLICATION SOFTWARE
ASSET MANAGEMENT
AUTO PARTS & EQUIP
AUTOMOBILE MFRS
BIOTECHNOLOGY
BREWERS
BROADCASTING & CABLE
BUILDING PRODUCTS
CASINOS & GAMING
CHEMS-AGRI/FERTILIZR
CHEMS-COMMODITY
CHEMS-DIVERSE
CHEMS-SPECIALTY
COMMERCIAL PRINTING
COMMUNICATIONS EQUIP
COMPU STORAGE/PERIPH
COMPUTER HARDWARE
CONSTRU & ENGINEER
Data as of 8/11/04
Microcap P/E (−)Premium
P/E 5-Year Average
P/E 5-YearAverage
Microcap P/E Discount
23.98
22.75
21.32
31.52
11.74
6.69
14.8
53.47
12.22
23.9
15.81
9.87
23.8
21.97
15.05
27.41
41.4
32.46
21.99
28.52
24.32
45.38
38.55
40.03
17.66
10.32
17.09
21.43
15.67
13.63
20.27
19.1
48.95
8.28
10.97
57.24
5.98
21.41
5.99
18.32
11.89
13.19
39.55
40.49
12.52
46.19
24.39
21.89
37.3
16.75
57%
25%
−1%
50%
−16%
−203%
−29%
8%
32%
54%
−262%
39%
10%
73%
−22%
57%
68%
−22%
−84%
56%
−90%
46%
43%
7%
5%
85
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Data as of 8/11/04
Microcap P/E (−)Premium
P/E 5-Year Average
P/E 5-YearAverage
Microcap P/E Discount
(Continued)
Industry
CONSTRUCTION MATRLS
CONSUMER ELECTRONICS
CONSUMER FINANCE
CONTAIN METAL/GLASS
DEPARTMENT STORES
DISTILLER & VINTNERS
DISTRIBUTORS
DIVERSE FIN’L SVC
DIVERSE METAL/MINING
DIVERSIFIED BANKS
ELECTRIC UTILITIES
ELECTRICAL COMPONENT
ELECTRONIC EQUIPMENT
ELECTRONIC MNFRG SVC
FOOD DISTRIBUTORS
FOOTWEAR
17.65
11.69
13.35
20.03
7
15.1
15.76
13.88
19.66
13.85
14.28
23.9
36.46
35.88
21.5
13.48
FOREST PRODUCTS
118.8
GAS UTILITIES
GENERAL MERCHANDISE
GOLD
HC-DISTRIBUTORS
HC-EQUIPMENT
HC-FACILITY
HC-MANAGED CARE
HC-SERVICES
HC-SUPPLIES
HOME ENTMT SOFTWARE
HOME FURNISHINGS
HOMEBUILDING
HOTEL/RESORT/CRUISE
86
23.65
23.24
11.07
40.88
32.45
21.08
14.12
23.84
21.35
14.17
13.33
6.96
7.05
13.01
12.66
11.94
19.53
11.11
28.28
16.3
24.62
16.24
14.29
11.72
22.07
27.17
30.64
12.21
13.58
63.98
18.2
7.75
16.58
9.73
25.26
11.93
21.98
19.45
30.18
11.75
20.19
14.14
9.76
26%
−8%
11%
2%
−59%
−87%
−3%
−77%
17%
−3%
18%
8%
25%
15%
43%
−1%
46%
23%
67%
−50%
76%
22%
43%
−56%
18%
−41%
17%
−51%
−103%
−38%
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(Continued)
Industry
HOUSEHOLD APPLIANCES
HOUSEHOLD PRODUCTS
HOUSEWARES & SPECS
IND’L CONGLOMERATES
INDUSTRIAL GASES
INSURANCE-BROKERS
INSURANCE-LIFE/HLTH
INSURANCE-MULTI-LINE
INSURANCE-PROP/CAS
INTEG TELECOM SVC
INTRNET SOFTWR & SVC
INV BANK & BROKERAGE
IT CONSULTING & SVC
LEISURE FACILITIES
LEISURE PRODUCTS
MACHINERY CONST/FARM
MACHINERY INDUSTRIAL
MARINE
MOVIES & ENTMT
MULTI-UTILITIES
OIL & GAS-DRILLING
OIL & GAS-EQUIP/SVC
OIL & GAS-EXPL/PROD
OIL & GAS-INTEGRATED
OIL & GAS-REFNG/MKTG
PACKAGED FOODS/MEATS
PAPER PACKAGING
PAPER PRODUCTS
PERSONAL PRODUCTS
PHARMACEUTICALS
Data as of 8/11/04
Microcap P/E (−)Premium
P/E 5-Year Average
P/E 5-YearAverage
Microcap P/E Discount
27.2
16.25
15.54
13.99
17.7
18.29
12.21
14.25
20.88
30.72
20.67
10.96
27.31
32.08
16.25
28.76
22.67
13.77
8.88
15.4
19.05
48.43
19.02
18
38.87
42.69
12.8
20.58
23.85
15.97
21.96
25.91
14.49
22.8
32
25.43
22.13
14.87
16.23
44.98
15.28
11.87
21.97
10.78
15.92
42.2
20.52
10.15
19.72
1.44
0
56.75
12.33
19.58
11.57
20.14
9.85
25.09
17.99
9.65
19%
−59%
7%
−63%
−81%
−39%
−81%
−4%
22%
−46%
26%
−8%
20%
66%
2%
−47%
9%
26%
−122%
91%
100%
−17%
35%
−9%
70%
53%
23%
−22%
25%
40%
87
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(Continued)
Data as of 8/11/04
Microcap P/E (−)Premium
Industry
P/E 5-Year Average
P/E 5-YearAverage
Microcap P/E Discount
PHOTOGRAPHIC PRODS
107.4
PUBLISHING
RAILROADS
REAL ESTATE INV TRST
REGIONAL BANKS
REITS EQ DIVERSE
REITS EQ HEALTHCARE
REITS EQ IND/OFFICE
REITS EQ RESIDENTIAL
REITS EQ RETAIL
REITS EQ SPEC/HOTELS
REITS EQ SPECIALTY
REITS HY HEALTH CARE
REITS HY IND/OFFICE
REITS MORTGAGE BACK
RESTAURANTS
RETAIL-APPAREL
RETAIL-CATALOG
RETAIL-COMP/ELECTRN
RETAIL-DRUGS
RETAIL-FOOD
RETAIL-HOME IMPROVE
RETAIL-INTERNET
SEMICONDUCTOR EQUIP
SEMICONDUCTORS
SERVICES-DATA PROC
SERVICES-DIV/COMM’L
SERVICES-EMPLOYMENT
SERVICES-ENVIRONMNTL
SERVICES-OFFICE/SUPP
26.68
27.88
9.16
15.03
6.92
9
8.72
10.13
11.3
5.63
9.59
19.29
10.71
6.53
21.36
19.95
39.96
8.64
18
19.41
7.7
18.2
35.91
56.3
20.24
20.88
43.22
36.59
24.56
84.86
17.4
14.12
14.99
7.86
6.7
5.2
9.48
7.61
4.51
7.23
35.2
2.09
4.42
16.01
23.06
48.75
15.59
23.52
20.8
15.39
2.31
27.13
43.91
20.98
20.1
41.88
21.57
38.16
21%
35%
49%
100%
0%
−14%
26%
40%
6%
33%
20%
25%
−82%
80%
32%
25%
−16%
−22%
−80%
−31%
−7%
−100%
87%
24%
22%
−4%
4%
3%
41%
−55%
88
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Micro Cap Stocks and the U.S. Domestic Economy
89
(Continued)
Industry
SOFT DRINKS
SPECIALIZED FINANCE
SPECIALTY STORES
STEEL
SYSTEMS SOFTWARE
TECHNOLOGY DISTRIB
THRIFTS&MORTGAGE FIN
TIRES & RUBBER
TOBACCO
TRADE COS & DISTR
TRUCKING
WATER UTILITIES
WIRELSS TELECOM SVC
Data as of 8/11/04
Microcap P/E (−)Premium
P/E 5-Year Average
P/E 5-YearAverage
Microcap P/E Discount
26.77
13.53
15.07
21.02
51.57
18.84
11.3
7.15
11.82
14.98
17.38
22.2
17.61
28.28
19.16
14.18
6.64
47.93
23.14
8.87
6.5
14.29
19.89
22.13
25.04
−6%
−42%
6%
68%
7%
−23%
22%
100%
45%
5%
−14%
0%−42%
FUNDAMENTAL VALUATION TECHNIQUES FOR MICRO CAP STOCKS
When analyzing fundamental valuation ratios for micro cap stocks,it is important not to let any single factor summarily eliminate astock  from  consideration.  Because  of  the  relatively  dynamicfinancial  nature  of  micro  cap  companies,  there  are  reasons,  attimes,  to  discount  some  factors  while  putting  more  weight  onother factors when reviewing the financial ratios of a company.For  example,  there  are  many  rapidly  growing  small  compani