Understanding the London Speculative Markets and the Secrets of How to Profit From Them

Virtually all the AIM and small cap oil companies are loss making, many with heavy capital expenditures and generous salaries. Thus, most need cash constantly. Very few have assets which offer adequate security to a lender, so financing has to be equity based. Broadly, there are two ways to do this. First, sell shares directly to investors who believe the company is a good proposition and actually want to buy the stock, even if they intend to flip it at a profit. Second, finance through the market.

The first is a quite straightforward proposition. The company's broker, or brokers, will contact investors on its list, or through others, and stock will be placed at a discount to the market price. These contacts are made on a confidential basis and until the placing is announced to the market, the investors are in possession of “inside information” which they are not meant to disclose or act upon. Obviously, they do and the market prices generally decline before placing announcements indicating this. In some cases, the information leaks widely and is even published leading to large price declines, which can require the placing price to be reset downwards. A good indication of the “quality” of the placing can be discerned from the level of the discount and the level of the leaks.

The shares issued in these placings are not necessarily paid for immediately. Settlement can be several weeks later when the shares are actually issued. During this time shares are often forward sold and this can be a time of intense promotion on social media as those looking to flip extol the attractions of the shares they want to sell to you. It is not necessarily guaranteed profit for those taking the placing or the would be flippers though, since the poorer quality companies can often rapidly go to a discount to the placing price. Some feel they have “joined the club” when they enter this circle, but in reality they are often just marks.

The second, financing through the market, is a far from straightforward proposition and there are three main ways in which it is done. First within this category is simply naked shorting, whereby a trader or “institution” (more on them later in the book) sells shares they do not own and simply fails to deliver them. They then approach the company saying they want to invest a large amount and cover their short via a direct issuance of stock from the company at a discount. Their selling also will have forced the share price down already and a good profit can be made without actually laying out any cash. Clearly, a lot of this is done on a nod and a wink and they sell knowing that they will be able to cover later on. The share price is damaged, but the company gets the cash and the directors’ salaries get paid, which to them is the most important thing.

The second main way within this second category are convertible loan notes. These represent loans made to the company, which are either repayable in cash, usually at a premium, or can be converted into shares at a discount. For cosmetic reasons, they generally have clauses prohibiting short selling by the holders, but these can be got around and are intended to be got around. The holder then simply sells shares short, which generally moves the price down, then converts the loan note into shares at a further discount to cover the short. It is virtually guaranteed profit for the loan note holder and often the only way that some companies can obtain finance.

The third way within this second category are investor sharing agreements. These are for the “institutions” that do not want to put up any cash at all and essentially are just a present by the directors to friends and associates. Under an investor sharing agreement, the company issues shares to the “investor” who sells them and then pays over a percentage of the share price to the company. It is money for nothing with zero risk for the “investor” who just sells shares they did not even have to pay for and keeps around 25% of the sale proceeds. They are only used by the very worst of companies.

Clearly, existing shareholders are greatly disadvantaged by all of the above financing methods and it is interesting to note that all the above financing techniques were made illegal in the United States in 1933 and these laws are enforced rigorously to protect investors there. No such protection exists in the UK.

Now, naked shorting also can be done on a large scale pre-placing in connection with a ramp. Indeed, it is much easier to sell large volumes on rising prices rather than falling ones. People buy a lot more when they see the share price going up. Vastly increased promotional activity often is an indication that a placing is on the way, otherwise why would someone pay for it? Trading long on this basis is highly risky, though, since the placing, often at a large discount could be announced any day.

Some pre-placing ramps are primarily to get the share price up, so the placing can be done at a higher level than present, but the key tell-tale is the promotional activity by the less than reputable (more on this further into the book).

It is quite easy to guess whether a placing is coming up simply by looking at the company’s accounts and working out when they are going to run out of cash. If you combine this with the monitoring of promotional activity, you will rarely be wrong with your placing forecasting.

Avoiding holding shares over a placing possibly is one of the most important keys to success with AIM and small cap companies, which is why understanding the promotional side is so important.

Companies with convertible loan notes outstanding are best avoided, since the share price is very much more than likely to decline. Companies with investor sharing agreements in place almost certainly should be avoided, since their share prices are virtually guaranteed to decline.

One mystery for many is that whereas some companies do have promise, others have little and people ask why do they keep these worthless, purposeless companies going The answer is simple: salaries for directors, fees for brokers, lawyers and auditors, trading profits for insiders with the shares. It is a pure exercise in cynicism. But with abusive promotional and financing techniques, even these types of companies can be kept alive.

Not all are deliberately dishonest, many are simply run by incompetents with a tendency towards pomposity. They engage in failed project after failed project, yet will never accept that perhaps they do not really understand the business. They actually believe they are serious business people, despite racking up seven figure losses year after year after year, and genuinely believe they deserve six figure salaries, large expense accounts and pension plans. None of the professional advisers say any different, because as long as the CEO can keep fundraising, they can keep earning too. Fees is what it is all about. The greed of the City knows no bounds and they will happily enter into business relationships with people whom they would not be seen dead with outside of work. Do not be fooled by implied endorsements from what may appear to be respectable associations. The names are only there because they are being paid.

Why do people buy shares in these types of companies? Possibly because they are foolish, with little knowledge and believe the story that the company is currently promoting or, more often, simply because they think the share price will go up. Indeed, that is basically how the AIM and small cap markets work. The majority of people simply do not care about any underlying “fundamentals,” their investment or trading decision is based solely on a belief that they can sell the shares at a profit later that day, week, month or year. And that is how these nonsensical companies keep going. Investing in them is simply a game of pass the parcel, but with the odds very much rigged against the investor.

In this situation, since the shareholders do not really care about what is going on, the directors can do whatever they want. Every so often there may be some shareholder activism, but generally very few investors turn up at company meetings, other than for free food and drinks, and hardly any vote. The asset for the insiders is not anything on the balance sheet, it is the public quote.

The reality is that with control of the board of a quoted public company, you can do anything you want. In the right hands, it is a licence to print money.

We are then back to the deal process outlined in Chapter 1, with the “asset” being a necessary nuisance to raise funds and promote. The reality is that virtually anything can be dressed up and, for a good fee, a professional will come up with a report endowing the asset with the necessary promise.

I mentioned earlier that there were acquisition deal types for the company other than paying cash. The consideration paid by the public company for the asset can, of course, be shares issued at a ground floor price. The identity of the counter party can readily be disguised through the use of an offshore company, itself with multiple shareholders who will each receive less than 3% of the public company’s enlarged capital. They can all in reality be the same person using entities with no recorded beneficial ownership, such as funds, foundations and companies with bearer shares. The offshore company owns the asset, the public company acquires the offshore company (something like an Isle of Man incorporated one can give it a more respectable look) and the public company shares are issued in consideration to the offshore company shareholder names, each of which will own less than 3%.

All that is needed to effect the above is cooperative professional advisors, since the purchase and sale agreement does not need to be publicly disclosed, since those undertaking such an exercise will of course ensure that the transaction will not be classed as a reverse takeover, where a prospectus or new admission document would be required.

Like some of the financing techniques I described previously, corporate abusers can not get away with such a transaction in the US in the same blatant manner, since the purchase and sale agreement would need to be exhibited to a regulatory filing and the nature of the shareholders would become apparent. In the UK though, it is all fine, or at least it is not found out, or examined.

All these essentially free shares are going to be sold into the market, though, depressing the value of shares which the public will have paid for. It is important to understand these matters, to see why shares can trade so far below their notional issue prices. It is simply because insiders secretly were given very large numbers of shares for nothing. The asset acquired by the company in such a situation equally will be worth nothing, regardless of the professional endorsements and valuations that come with it.

At the same time, it would be wrong not to say that not all companies and directors are the same as those described above. The problem, though, is that many are, hence the need to be aware. At the end of the day, directors are in it for themselves and, notwithstanding what they may say, the interests of investors are very low down their list of priorities. Investors only get considered when they need money. They are not regarded as the legal owners of the business, rather just as a necessary evil. Only when directors need, or feel they will need them, will the investors interests be considered.

Remember:

You have to look out for your own interests and understand that the key to a promising stock play is always to be heading for an event, fully financed. This is the point in time when most share price rises take place. As I said before, you do not want to be in at an earlier stage, with the main financing still to be done, or be in long after the event, when the development finance will have to be done, but without the original excitement. You never want to have to guess, rather to be certain. 

Chapter 3 follows…