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- Advanced Market Knowledge - Part 2
One of the greatest problems faced by investors is caused by their own failure to read and/or understand the disclosure information available. Some act simply based on a tweet and, to many, their concept of “research” is to read some recent posts on the message boards. The most diligent might listen to the latest interview.
Hardly any read the company announcements and virtually none the regulatory filings. Yet these are the key documents mandated by the authorities to be published for investor protection. Filings can be several hundred pages long, but at the very least it is important to study the history of share and warrant issuances and understand the current situation with those.
The share prices of some companies never go anywhere, even with the most exciting news, and this can be due to large numbers of shares having been issued to associates at very low prices at an earlier stage. Buyers are often up against a wall of selling with some companies and a lot of investors just do not understand where it is coming from. Many do not even want to know.
There is often a reluctance by investors to confront facts. They know a side of the story that they like and they do not want to hear anything that contradicts their beliefs. This weakness contributes to huge losses. In reality, if something is not what you think it is, you want to be out of it. Unfortunately, most will not accept that they have made a mistake until it is too late and their money is lost. Pride is the enemy here.
The only way to succeed, of course, is to base decisions on facts, not fallacies which you would like to be true. Accepting reality is essential. Conviction can only be based upon your own assessment of the facts, not the thoughts and opinions of others. You have to look carefully at the company of interest and, at a minimum, see how many shares were issued at what prices, how many options and warrants are outstanding and again at what prices, what the cash position is and for how long that will cover the outgoings - plus what news is going to come along in the meantime. That assessment will immediately reappraise many companies for you and should always be done pre-purchase.
It is critical to always remember that many commentators and message board and/or social media posters have their own agendas and will deny the truth of points you may raise in public, particularly regarding sensitive subjects such as prices of share issuances, numbers of outstanding options and/or warrants and possibilities of upcoming placements. You have to be strong enough to believe in yourself and your own knowledge. The opinions of the more abusive ones in particular should be ignored completely. Them trying to shout you down really just proves your point and confirms your concerns.
Remember also, the “other side,” the directors and the promoters, are not playing on the same team as you. Investors are who they feed off. Your money is their living. Read the company announcements, the regulatory filings and ignore the rest of it. Focus should be on share prices and how they are moving, not the comments of others. Do not allow yourself to be misled.
One of the tricks to look out for is the “premium placement,” used to suggest that the share price is too low and the company is so good that “institutions” are willing to pay a premium to the current share price. Obvious question here of course is why do they not just buy up all the “cheap” shares in the market below that price?
Let us look at what is really going on here and the regulatory filings should guide you. If you have a party or parties with a large holding issued at a low price, it actually makes sense for them to use some of the sale proceeds to take a premium placing to attribute a value to the remaining stock, which can then be easily touted and sold on the basis that private investors can now get in at a better price than the “institutions.” It is cynical, but that is what they do and it works for them. Realistically, why would an institution want to pay more, when it could buy in the market for less, or undoubtedly insist the company issues the shares at a discount. It is really only a connected party who would want to do that.
One is confronted with numerous deceptions, all designed to make investors think that the shares really are more valuable than the price prevailing in the market. In addition to “premium placements,” you see the same technique being applied with options issued well above the current market price (more on this later), directors exercising warrants above the current market price and, of course, ambitious, often wholly unrealistic and unachievable price targets being set, particularly by brokers.
Generally, brokers’ price targets are worthless. It is rare indeed that one is ever reached. Essentially, they produce their “analysis” and “research reports” with price targets either as a service to an existing client, to attract a new client, or simply for payment. However, these targets can and do impress and seduce the inexperienced. Even those who can see through the social media promoters, often are gulled by the brokers, to whom they afford an undeserved credibility and respect.
Similar reports also are produced by self styled “independent” commentators for payment. Analysts and research houses further produce reports - with price targets - for a fee. Regardless of the source, these reports add credibility to the promoters’ arguments and are used to deceive many. They are invariably best ignored.
It is important to put the quality, and hence value, of these projects into perspective. To do that, it is helpful to understand how the oil business (which is being used here by way of example) actually works in the real world and how genuine projects are created. That starts with geology. Knowledge in this area is always advancing and expanding, and each new development provides further information, which in turn leads to new prospects being generated by geologists. These geologists are either employed directly by oil companies, or work freelance and sell their intellectual property on a prospect by prospect basis to oil companies.
At this stage, the land is neither leased, licensed nor permitted, and there is no “asset” as such to sell. Generally, it is the smaller companies that take the project on at this stage. The larger companies will have their own full time geologists employed, plus professionals to deal with the land work, but these projects will never enter the small company world.
Having reached an agreement with the geologist, the next step will, in North America, be to lease the prospect acreage and, elsewhere, to licence or permit the land from the relevant Government or State. As outlined previously, it is not a particularly difficult process to licence or permit tracts, although it can take time.
Some of the small companies doing this are public companies themselves and they will be leasing, licensing or permitting these prospects with a view to farming them out and/or using them as an asset to justify additional fundraising. Others are private companies, looking to obtain the hydrocarbon exploration rights purely to farm out. Essentially, two types of prospects get permitted: ones that can be farmed out to majors, which is usually the objective; and ones that can not. The latter is the stock of the lower quality micro cap companies, who are not able to generate their own and/or are looking for a deal ready to go.
There are a number of reasons majors or the larger oil companies do not want to get involved in some projects, the main ones of which are: they do not view the level of exploration risk as acceptable, they do not view the prospective resources as sufficient, they do not view the project as commercial, and/or they do not like the environmental issues involved. If the prospect is decent, though, they take them, usually reimbursing the back costs plus a little extra, leaving the farmer (the company farming out the permit) with a carried interest, in respect of which the farmee (the company taking the farm-out) pays all the costs through either the seismic phase, through the first (or sometimes second) drill, or even through to first oil, depending on how well the farmer can negotiate.
Few of these projects ever actually make it to production. From the point of view of the major, they are essentially just paying option money to acquire them, which is worth it to take the project under control for a few years. Sometimes they do nothing at all; sometimes they shoot seismic, which has the additional benefit of building up their knowledge of the regional geology; sometimes they will drill an exploration well. But not that many go on to be commercially developed. In the grand scheme of things for the large oil companies, it is all worth it to find the occasional elephant field.
The prospects that go to other companies are essentially the ones that the majors and other large oil companies, who actually know what they are doing, have rejected, either initially, or through the life of the permit (think about how many times you see an exploration or appraisal project being promoted where they are talking about a well being drilled on the acreage by a major years ago). But what trickles down to the average micro cap company is rarely the best and is of a quality that often really only can be funded by a large number of less informed investors chucking in a few hundred or thousand pounds each, essentially as a bet.
Even in the situation where a micro cap company farms out to a major, the project rarely goes the distance and the relatively small amount of money they receive upfront often barely covers a few months of the directors’ salaries. The credibility of the involvement of a major is great for raising further money from investors though.
So, in reality, what the brokers, analysts, research houses and “independent” commentators are ever really talking about, even in the very best case with these companies and their projects, is something that only ever has the remotest chance of making a profit for the company’s shareholders. Their investment thesis relies on perfect outcomes, without consideration of the reality of the the oil game. It is important to think about this and understand the implications.
Also remember that even when it does all work out and the project proceeds to the production stage, the development finance can end up having to be arranged on terms that result in a loss even for those shareholders who took the initial exploration risk.
You really have to see these companies as being purely for trading in the shorter term, and they can be very good for that, but never as investments for a long-term hold. The projects can be beguiling, but never allow yourself to be seduced by them.
Back to the subject of structural trickery, like the premium placing mentioned earlier, the importance of directors buys also should be discounted. Look carefully at the amount of money they are investing compared to the amount of money they are taking out of the company each year and the number of shares they already own. Rather than signalling confidence, smaller purchases indicate the opposite, since they are clearly contrived and being done solely for promotional purposes.
Awarding themselves options priced well above the current market price is an equally deceptive and misleading practice. In reality, it indicates nothing at all. It is important to view all these devices as spoofs and discount them. Most people are convinced by these things, that is why those running the companies do it; do not be one of those who are persuaded by these tricks.
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Many things in the micro cap markets are not what they seem or appear to be. “Institutions” are one of those. When people hear this term, they think of something solid, like a bank, but on these markets the unnamed ones are actually quite different. Imagine more a name on a board outside a dodgy lawyers’ or accountants’ office somewhere on an island or in a smaller state, which makes its money by charging registration and incorporation fees and turning a regulatory blind eye to any inconvenient matters.
The traditional locations are familiar: Jersey, Guernsey, Isle of Man, Luxembourg, Switzerland, Lichtenstein and most former British overseas possessions. Regulatory pressures have curbed many of their activities now and new locations have been established in places such as Dubai and Singapore. It does not matter that much though. Micro cap investing “institutions” rarely publish their actual address and, in reality, they are usually just controlled by someone back home, with the directors of the “institution” being nominees.
Even with institutions you may have heard of, it is important to understand that funds can be compartmentalised. Which means that someone can have a fund within a fund that accounts separately. Essentially, they can be used to avoid or evade regulation, reporting and tax. Important to understand from the investor’s point of view is that the name is not necessarily an actual endorsement of the investment by the named institution. As with most things micro cap, little of it actually means what it seems.
It is easy to set up an “institution” if you want to. Many legal and accountancy firms in the various tax havens offer such services. You can get them licensed too for an even more respectable look. If the name is not being disclosed to the public, then it is really just a question of what the professionals involved will live with. Perhaps a foundation or trust, or a nicely named company with bearer shares will be acceptable, none of which need necessarily cost more than a few thousand (or even just a few hundred) dollars to set up.
“Institutions” feature large in micro caps, particularly the usually much higher prices they have paid for shares in certain companies. But think about this for a minute. Are the managers really so stupid that they constantly invest in hopeless, worthless shares? No, they are just a conduit to put the necessary money into the company to keep it going, with the added bonus of what appears to be a seal of “institutional” approval. As mentioned before, those “institutional” purchases at higher levels also can be used as a promotional tool to persuade the public that they are getting a “bargain” - and allow the “institution” to sell large quantities of previously acquired, lower price stock.
As mentioned before, these “institutions” also are used for naked shorting, where shares that are neither owned or borrowed are sold into the market, not delivered and then the unnamed “institution” takes a placement directly from the company to cover the short. This is a virtual licence to print money and, on “a nod and a wink” basis from the company, there is simply no risk. Just sell and sell, push the price down and then cover via an “institutional placement” from the company at an even further discounted price. You see this time and time again with certain “do nothing” companies, the necessary volume to sell into being generated by the usual promotional teams.
Some institutions are of course genuine, but in many situations it is difficult to see why they are investing, particularly with companies and managements that continuously lose their shareholders’ funds. It is a murky area, though, often with “quid pro quo” compensation.
Equally murky can be the actual management of these companies. The person really in charge often operates behind the scenes, although if they are presentable and without a criminal record they may go upfront either as CEO or another board director so that they can openly represent the company. If they are barred as a director, then they have no choice but to remain behind the scenes. Generally, these people are charming, but dangerous. There is no shortage of outwardly respectable people, however, who are happy to take their money.
The professionals involved (who are selected on that basis) also are happy to take their instructions from the shadow director as long as their well padded invoices are being paid. To get an idea of just how padded these fees can be, does it really cost hundreds of thousands a year to run a do little or nothing company?
Many companies do indeed have nothing: just a letter of intent or memorandum of understanding, all kept alive by the hurdles deliberately placed in the way to delay completion and keep the story going. This business is about one thing: selling shares to private investors. Never, ever lose sight of this. It is key.
What the money is being spent on is what the controller knows is essential - names: credible looking directors, reputable sounding auditors, brokers and lawyers. The asset comes second. They all know that even with an asset, the underlying fundamentals remain junk. That is not a problem if you just want to buy and sell shares in these companies short term, but it is extremely dangerous to your wealth if you decide to hold.
Some know these types of companies are frauds; the majority think these scams are genuine. One reason is the deference and respect incorrectly awarded to professionals associated with the companies. Again, just look at how the promoters play on such associations.
Always remember, people generally do not want to hear the facts, indeed, many get upset by them. Those involved with the disreputable small public companies do not want to know either. Try writing a letter of complaint to one of these companies’ auditors or attorneys if you want to check that out. You will receive a very stuffy response, if indeed any at all.
The other reason most people think these companies are genuine, and the most important reason perhaps, is the fact that they are listed/quoted on a stock exchange. That to many is the imprimatur of solidity, respectability, seriousness and quality.
You can see how important this is by the way that listing/quotation is highlighted on these companies’ websites. However, in many cases, no one has ever opined on the merits of these companies. Any review of regulatory filings is purely to ensure that disclosure complies with legal requirements. This allows serial losers (from the point of view of the shareholders that is, since these individuals actually profit hugely) to take the helm at company after company after company, wiping out shareholder value time after time after time. And it keeps working for them. Somehow to investors, this time always is going to be different.
Back to the business of these companies and I shall continue with oil company examples, a deal type that is worth understanding further is the farm-out to the public company. These are quite common - and invariably bad for investors. Usually what happens here is a public company farms-in to an existing oil field on the basis that it pays a percentage (usually 100%) of the cost of working over or drilling a well(s) in return for a lower percentage interest (usually 50%) in that well and sometimes the associated land tract, occasionally the whole field.
The reason the owner of the field does this is simple: the economics of doing the work do not stack up. The public company does not really care about that, because it gets a deal to report and a flow of further announcements. Nothing they do is ever going to make any money anyway. Usually, the owner of the field or one of their contractors will do the work and the involvement of the public company will be limited to sending money. Sometimes this is covered over by the appointment of an “exploration” or “technical” director, who just wastes further money travelling to the field to “discuss” operations in which the public company actually has no say.
Work overs and infill drilling usually see “success” (sometimes even with decent looking initial production numbers), but the economics simply are not there and the well will never recover its cost. That does not matter for the field owner though, who is on a free ride for half of the production and probably has made a profit already out of the money sent by the public company for the operations.
Reality eventually dawns in the company’s accounts one day, but by then, they have already moved on to the next project, with the farm-in forgotten. That paid for the content of announcements, that is it and it is all they ever wanted. The deal has simply been used as an excuse to raise money. Everyone at the company will have made money, as will all the professional advisors involved. Some investors will have made money from trading the shares. Those investors who may have believed in the project and held have lost their money. That is the way it usually works unfortunately.
Part 3 follows…