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- Advanced Market Knowledge - Part 4
One subject which is rarely heard discussed is audience. Yet it is one of the most important aspects in ensuring a strong promotion and explains why those in charge at these companies can prefer to use a shell with an existing shareholder base for new deals. With an actual IPO, the audience has to be built from scratch. With a shell, thousands of shareholders and an instant audience is already in place.
There is an old saying that an investment is a trade gone wrong. People do not like taking losses and often hold until the bitter end hoping things will come right again. Stock once bought tends to stick and, even better from an organiser’s point of view, many investors tend to make the mistake of averaging down their losing investments. And what better time to average down from the existing shareholders’ point of view than when a company returns to the market with what looks like an exciting new deal.
For a truly strong promotion, though, the old shareholders will not really be enough and when it comes to obtaining future shareholders what matters most is the advertising and marketing spend, plus the perceived attraction and excitement of the new deal. There are numerous possibilities for these, each with their own advantages, or otherwise.
Let us look at some examples in the oil and gas sector (the following deal types are not exhaustive, but provide a reasonable overview):
Weakest are the “transactions” which in fact are only letters of intent, memorandums of understanding or conditional sale and purchase agreements, i.e. non-binding and often just aspirational. Of course, these are the easiest types of “transactions” to do and can be done with little or no cash. Indeed, all it requires is for the party on the other side to say they have something. It does not necessarily mean that they do. Nevertheless, a skilled promoter can spin such a story, indeed some can even achieve considerable success with this, and it can all be dragged out and hyped as each “milestone” is reached, but as these things go it does not really have that much underlying strength. And, at the end of the day, of course, even if the deal does happen, it is inevitably still going to need to be financed.
This is the killer from the investor or trader’s point of view, because even if such a proposition does graduate to a more tangible level and an acquisition actually is completed, at what level will the financing take place and will it be straight equity or convertible debt. The deal being financed really should be a pre-condition of any investment or trade. I have stressed the importance of the company being fully funded and it is rarely a good idea to invest before this stage.
Moving on to actual deals, the company generally will either be buying a project where it will act as the operator, or farming-in to an existing project with a third-party operator, sometimes by buying an existing participation. Transactions in the first category often can go wrong, since no matter how much the company’s management may fancy their abilities, in real life they may well turn out not to be up to it and this is frequently the case. There are many examples of abject failure by micro cap companies which have tried themselves to act as an operating entity. The risk of their projects is bad enough without the addition of their own management incompetence. Much better if all that is left to actual professionals who know what they are doing.
Deals in the second category, particularly if there is an experienced and reputable operator, especially a major, involved are much safer. If the numbers are good then this type of transaction can often be the best from the point of view of the effectiveness of the promotion and subsequent share price performance. Important is the potential future news flow (some are likely to issue more announcements than others) and the promotional ability of the team involved. Some projects also can capture the imagination more than others and a further factor often is how well it all can be presented.
Sometimes the project will have been generated by the company itself, who then will either farm-out a percentage to cover costs and/or raise the necessary finance. Again, focus really has to be on the anticipated news flow and the quality and strength of the promotion. Ironically, it often works out better for short-term shareholders if the public company being promoted is the one farming in, rather than the one farming out, even though the economics would suggest the opposite. Regardless, as I discuss below, it is always best to wait until there is a fully financed drill.
Deal types then break down into various categories, some of which are better than others. Worst is something in the nature of a farm-in to work over existing wells, with the public company taking a share of any increased production. As mentioned before, the main reason the other party enters into such a deal is that the operation is not really economic. There is no big money in such a project anyway and, even if there was an operating surplus, which is unlikely, it would never get anywhere close to covering a public company’s overheads. These are deals for those who really just can not find anything better, but do have the advantage of not requiring too much cash. One does see them promoted, but not often that successfully.
Moving up the scale, but only slightly, would be a farm-in to drill new wells (infill) on existing producing, or abandoned previously producing acreage. While the counter party will be entering into such an agreement since they are not too impressed with the economics and do not wish to invest their own capital, there is more chance of the public company obtaining some decent looking initial production numbers and being able to put out some positive sounding announcements. Longer-term, the company probably will be lucky even to recover its investment, but short-term there could be some promotable numbers with initial production rates and future cash flows being (usually wrongly) extrapolated by promoters. It is all a very long way from meeting any “certainty” criteria though and in my view such deals have little attraction.
Parallel to this would be the acquisition of an old field, either with some existing production, shut-in wells or abandoned. The economics might be better than with a farm-in, but these really are projects for the hands-on, with experience and without any heavy overheads. They are not where riches may lie for the shareholders of small public companies.
A variation on the above and usually well avoided, is a company claiming to have some type of new technology, which can achieve production results which have eluded previous operators. Invariably, these types of companies are scams. If these technologies actually worked, established companies would be using them.
Slightly further up the scale would be a modest production acquisition. Again, there is little real potential since all there actually is going to be is a bread and butter business, but now having to carry champagne and caviar public company overheads. These deals rarely work out for the shareholders, but for some reason, many investors can get excited by such transactions, and the other two types mentioned above, thinking that they are investing in a “real” oil company and, sadly, even when they lose their money, most still do not get it. These projects can also sometimes be profiled as “technology” type deals, with new production methods being applied to old fields, but as stated above, it is usually just the sign of a fraud.
Next up would be a farm-in to an existing exploration project, but this only really starts to become exciting if there is a drill coming up. If it is still at the stage where seismic needs to be acquired, it is unlikely to be a great near-term share price performer and the drill probably is still going to need to be financed anyway. As I have said before, being fully financed is an essential prerequisite.
Strongest is a farm-in to an upcoming drill, although the numbers have to be there to make success a potentially transformational event compared to the size of the company. As I have already mentioned, it needs to be fully funded, something that usually would be, and often is, done around the same time as the farm-in announcement. These types of deals are the ones that tend to work best from a promotional and short-term share price appreciation perspective.
It is critical to emphasise yet again that the project must be potentially transformational and it must be fully funded. It is only then that the share price has the unfettered potential to run upwards as the key event approaches.
While there always will be some exceptions, generally these are the main types of deals. Fundamentally, what is important is whether there is a story with serious upside, good news flow and strong promotion, which is not going to have a damper put on it by further fundraising. Favourites in my opinion in the oil sector (being used as an example) are high impact exploration projects with an imminent drill.
However, there are some important further aspects for these plays to be successful from the investor’s point of view. You do not want to see the placing to fund the project taking place at an already ramped up share price. The last placing, delivering fully funded status, is best if it takes place at a low point, not a high point, ideally well below any recent highs.
There need to be no convertible loans, investor sharing type agreements or similar devices outstanding. These simply constitute a death spiral and will kill any upwards share price performance dead.
Equally, it is best to avoid companies whose managements have previously demonstrated a liking for such arrangements. These are highly profitable for all involved, with the exception of the company’s shareholders. It is a step too far at the expense of investors in what is already a very one sided game in favour of the management and professionals in control.
Crucially, there must be no large numbers of cheap shares recently issued. It is necessary to watch out for conversions of debt and issues of shares during any preceding suspension, hence the critical importance of actually reading the relevant part of the regulatory filings if appropriate.
It is generally better to buy in the market on subsequent weakness while the placing churns before the run up. Indeed, it is often possible at some point to buy under the placing price. Scale in. Buy in stages.
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Most people see business as the selling of a product or service at a profit. The key essential is to offer a product or service that customers or clients want to buy. Without that, there is not a business. Obviously there are exceptions in the form of companies developing a product or service for future sale, but the financing of that is based on rigorous due diligence by the financiers. This is fine for real businesses, that is how it works, but when we enter the world of micro cap companies, we go through the looking glass.
Many micro cap companies are not focussed on selling a product or service, they are focussed on selling their shares. People do not even buy these shares because they want them as an investment, rather only because they think they can sell them again very soon at a profit. Most buyers do not really care that the funds are to finance the directors’ lifestyles, rather than develop a genuine business; ideally, they probably would like all the money to be spent on promotion. Sadly, though, some buyers actually believe the story, hold the shares and in the vast majority of cases, lose their money.
The only people carrying the risk here are the investors. The directors generally have nothing to lose. They take their salaries, expenses and even bonuses regardless of the size of the company’s losses. If they do own shares, usually it will be ones they originally were issued for free or for very little; alternatively, relatively nominal numbers of shares that they have bought in the market to demonstrate “confidence.” In some companies, the directors do not own any shares at all.
Generally these companies can push on with their business projects for as long as they want, regardless of failure, and well beyond the point that any conventionally financed project would be able to go. They simply keep selling shares at ever lower prices, cooperating with promoters as needed by delivering bullish sounding news. As long as investors or traders think they can flip their shares at a profit, the game continues. All risk is on the investors. The insiders can only profit.
All the way through this, a project is being pursued, often completely cynically. Even years later and with millions of shareholders’ funds wasted, they can still keep going with their announcements, “experts” reports, investor meetings and presentations. The unfortunate people who believe them keep buying at the new, ever lower, even better “bargain” prices. In the most tragic cases, people can invest everything they have and end up losing their life savings.
On the other side of the equation, everyone involved on the inside keeps earning. The directors, the auditors, the lawyers, the brokers, those short selling the shares before placements, the promoters, the paid for commentators. All without any risk at all. It is highly inequitable and very important always to remember this. Outside of the world of real businesses with effective corporate governance, any investor is very much exposed, with a serious risk of losing all, or a large part of, their investment.
At the end of the day, all the cash is coming indirectly from those buying in the market and directly from any unfortunates who got duped into taking a bad placement, or if it was a good one, got greedy and did not sell at the time at a profit. The situation with the “institutional” shareholders in these micro cap companies has been discussed previously.
Think about how the money flows right from the beginning and let us take the example of a brand new micro cap company. It is generally going to commence business by acquiring something from the people who are putting it together, for example, an oil and gas exploration permit, a mining lease, a patent, even just an idea. Ostensibly (and sometimes they are genuine, but can soon become corrupted) they are doing it to raise finance for the project. To take it public though will cost a very significant amount in professional fees. That does not make sense if the project is strong enough to raise the necessary funds from venture capitalists. The usual rebuttal to this point is that the venture capitalists are too demanding, want to impose too many controls and conditions, etc. Often, the real objection is that the venture capital firms are not going to allow these people to take money out of the company before there has actually been some success. And there it is: they want to raise the money from investors and they want to get paid either way, success or failure. They would also like to sell their shares in the company if possible and make several million for themselves before it is even known whether or not the project is a success and before they have even returned any money to their investors.
The whole thing starts from a fairly bad place, often made worse by the type of behind the scenes characters who will front the substantial costs. The calculations are going to be about who gets how many shares and, most importantly, what the selling restrictions are. The more sophisticated, with a longer-term view, will look to ensure that however it is structured, using tame non-executive directors they control the board. And forget the idea of the professionals involved doing rigorous due diligence. For those involved with these types of companies, the only qualification required is the ability to pay their invoices.
Everyone right from the outset is thinking about making money from selling shares, not any actual business, which before very long they will not care about at all, but know they have to keep it going to keep getting the cash. To invest longer-term in such a company is madness, since it only can keep raising the necessary funds (often principally to cover directors’ salaries, fees and expenses, plus public company costs, “working capital” needs they call it) at ever decreasing share prices.
Funds at this initial pre-admission stage are raised from outsiders via an IPO process. It is nice to raise a large amount, but not absolutely necessary, the main objective is to get the company listed and trading. Quite often, the shares just go to a discount, due to some insider being able to sell from the off. The main thing is that they have got a vehicle and whoever actually controls it then can do whatever they want with the company.
If the deal does not work from the perspective of obtaining investor interest in the project, then the company can simply change direction, which also provides the opportunity to remove any individuals who may have become troublesome and are not “on the same page” as those in charge who are focussed on getting the short-term cash. This can easily be done: remember the objective of the professional operator right from the outset is to control the board, so they can then do whatever they want.
The hard work is preparing and clearing the initial regulatory filings and that is what most of the upfront money for the professional advisers is for. Thereafter, if the company changes direction gradually, it can hope to avoid the need for another lengthy, detailed filing, which in some jurisdictions can also entail a lengthy trading suspension, from which some companies never return.
Once the company is up and running, matters get easier for the controller though. As mentioned above, providing the company does not enter into a transaction that could be classed as a reverse takeover, there is no need to produce any further detailed documentation. It can transition into another area with ease. Some companies simply follow investing trends, jumping on every band wagon they see.
Remember, the cash is always coming out of the market, whether the shares are being sold short to be covered in later placements, or being flipped by those taking the placements to recover their investments. That is why promotion and volume is so important. But with what is clearly an inefficient use of capital (it is being used to cover bloated public company overheads, large salaries and the losses of the low quality projects in which most of these companies are involved), their shares are simply never good investments beyond a short-term trade.
The greater problem and it affects everyone involved, is that with no wealth being created by these micro cap companies, in fact quite the opposite, the market as a whole must continuously contract due to the money being sucked out of it and thus can only keep going at the same level of activity in total money value if new investors continuously get involved. It is not business as normal business people understand that word, rather a constant transfer of wealth from investors to insiders. It is simply not where to invest long-term.
This is why it is necessary to be extremely cautious. Money can be made, but only at a certain part of the cycle. Holding the vast majority of these companies beyond the short-term is most likely to result in losses, often substantial.
You may note that very few of these companies engage in usual businesses. If they did, the nonsense would become apparent. Everyone would see from the level of the losses the absurdity of paying six figure salaries from a coffee shop size business and also at the same time be carrying a huge public company overhead. That is why they have to trade on hope and oil, mining, pharmaceuticals and technology are perfect areas for that.
Essentially though they do it to transfer money from your pocket to theirs. They are not on your side, no matter how friendly they may present. They see you as a mark. And do not think you are just buying stock from other investors in the market, most likely it is coming from someone who either has got, or will get it from a placement, effectively putting the money straight into their hands.
As I said before, what you buy is hope, and the chance to flip the shares you have just acquired to someone else higher up. The conditions are an exciting event coming up and no further issues of stock in the meantime. I would suggest to always remember that.
Of course, you could question the desirability of getting involved in any of this, but I think the reason that it is attractive is because it is an imperfect market. I do not believe that many people involved in perfect markets, Forex for example, really can make continuous profits. The only ones who actually can do that are those traders at the banks who can see the order flows. Yet with these small companies, playing them right, you can consistently make money.
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I have talked a lot about fundamentals and how with micro cap companies perception can be more important than the underlying facts. What actually is needed is for the company to be able to put together a credible, compelling story which investors believe and is capable of moving the share price significantly higher.
It is the buying of others that matters and they are going to be driven by their perception of the company and project, supported by promoters’ and other investors’ endorsements. A strong, believable story with these micro cap companies is key. It is the headline points that actually are going to affect the share price.
Even if you do the detailed research, or understand it all well enough not to need to, what do you achieve without advance knowledge of the company's financing plan? Without that, it is not possible to know whether an investment actually will be profitable. So with these shares, one is always back to a short-term trading approach between financings.
Generally no public company, no matter how bad, can not raise money in the market. An announcement of a new business direction can be made, promoters engaged, volume created, shares sold and money raised. But these sort of pump and dumps will not get you anywhere over time unless you are part of the inner group. You might make some money on one or two, but overall you will lose.
You have to look for credibility in a company’s announcements. If they are shifty or evasive move on. Serious investors see through it. If it is all just forward looking statements, that again is a ground for caution. Key if there is going to be strong short-term share price performance is a compelling and credible, highly promotable story, with big headline numbers.
Announcements can appear ambiguous sometimes and are often deliberately drafted that way. They can play with tenses, dates and conditionality of events. However, they have to be true, unless we are looking at an outright fraud with the professional advisers complicit. Therefore, reading carefully, word by word, it is possible to decipher what they actually mean. Most people will not do this and indeed can get very angry if it is pointed out to them that the actual meaning of the words is different to what they would like them to mean. Being diligent and dispassionate will give you a big advantage. Knowing what it actually says rather than what other investors might like it to say will put you well ahead of them.
One of the reasons the promotion game works is because most people just see what they want to see in company announcements. The understanding of someone holding (looking/hoping/praying for good news) often can be diametrically opposed to someone not holding. The holder seizes on anything that can be interpreted positively, ignoring the parts that in fact are negative. The reason this is important is that these companies need new buyers, who do not already hold the shares, so credibility in the announcements is essential.
As mentioned, the key is always to be heading for an event, fully financed. This is the point in time when most share price rises take place. You do not want to be in at an earlier stage, in the case of oil and gas with the exploration financing still to be done, or be in after the event, when the development finance will need to be done, but without the original excitement.
It has to be emphasised yet again that the project must be potentially transformational and it must be fully funded. It is only then that the share price has the unfettered potential to run upwards as the key event approaches. Fundamentally, what is important is that there is a story with serious upside, good news flow and strong promotion, which is not going to have a damper put on it by further fundraising.
As stated previously, there are some important further aspects, which I shall repeat: you do not want to see the placement to fund the project taking place at an already ramped up share price. The last placing, delivering fully funded status, is best if it takes place at a low point, not a high point, ideally well below any recent highs.
There need to be no convertible loans or similar outstanding. These simply constitute a death spiral and will kill any share price performance dead. Equally, it is best to avoid companies whose management have previously demonstrated a liking for such arrangements. These are highly profitable for all involved, with the exception of the company’s shareholders.
Crucially, there must be no large numbers of cheap shares recently issued. It is necessary to watch out for conversions of debt and issues of shares during any preceding suspension or prior to the original admission, hence the critical importance of actually reading the relevant part of the filing(s) if appropriate. You need to know who could be selling, at what price, and how much.
Rather than taking placements, it is generally better to buy in the market on subsequent weakness while the placing churns before the run up. Indeed, it is often quite possible at some point to buy under the placing price. Scale in. Buy in stages.
If you fancy the idea of taking placements, remember that the broker will be calling you regularly touting all sorts of unattractive propositions and you risk being badgered into transactions that may not be in your best interests. Better to remain detached and review everything from a distance without any pressure.
Do not allow yourself ever to be triggered by a social media post, or someone else’s opinion. Ignore the promotional marketing aimed at the less knowledgeable, focusing only on the points that actually are important. Conviction in purchases is key and you will not obtain that just by listening to other people. You have to believe it yourself.
Now, not all companies are as bad as I describe, some directors genuinely are trying to succeed, but the financing dynamics which I have discussed previously are always there. Look for the shorter-term run rather than the longer-term hold. Control emotions and never fall in love with a share.
My take on stocks and the market is different to many, but the approach I adopt has served me well. It might not result in as many trades, but what it does do is ensure that virtually all end in profit.
What I like most is a big drill, not one being undertaken by an already producing company, rather by an exploration company with no production. The numbers have to be potentially transformational in relation to its current market capitalisation and I want to see the drill being financed entirely by equity (no convertible debt or anything similar) at a share price towards the bottom of its recent trading range. Best is a company that has been around for a while with no large tranches of cheaply issued shares extant. Credible management is good, as are credible partners. Let them do their placement, then gradually scale in as it churns (remember there has to be time enough for that between the placing and the spud). Then, providing they are not lying about dates, contracts, etc. (which is why I keep stressing the word credible) the share price will start moving up. I de-risk as the price rises to run the whole position for free and thereafter start to gently bank profit.
The same principles apply for other sectors: the company just needs to be heading for a potentially transformational event, fully financed. Scale in slowly to something where the dynamics indicate it will move up.
These trades do not happen every week, but there are enough every year to make good money. Success also requires doing nothing at times, yet doing nothing sometimes is the hardest thing to do. People often want to be in every trade, but to win it is important to learn to trade only when everything is in your favour.
Other plays than outlined above require more subjective analysis. To do this, you need to develop a good understanding of the market and the information sources should be company announcements and share prices, not uninformed gossip on social media. The more you study the raw data, the more you will learn about it. Decisions must be based on facts, not fallacies which you would like to be true. Conviction can only be based upon your own assessment of the facts, not the thoughts and opinions of others. You have to be strong enough to believe in yourself and your own knowledge.
Remember that ultimately these companies’ business projects usually fail. Focus on the strength of the near-term story and the key points that actually are going to impact the short-term share price performance. The test again is does the company have a credible, compelling story, strong and believable enough to entice large numbers of future investors to buy it, and which is sufficiently powerful to be capable of moving the share price significantly higher. Keep all of this in mind and ignore the irrelevancies.
As I have stressed, it requires patience and a control of emotions, in particular FOMO (fear of missing out), but with discipline it works. It is important to be relaxed and never over extend yourself financially. That way, as I said before, trading and taking profits becomes both pleasurable and effective.