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How to Not Lose Everything When Buying Micro-Caps

- By Rupert Hargreaves

The majority of the world's most famous investors made their name investing in small-cap and micro-cap stocks. These are the best sectors to generate outperformance in the markets because it is in these regions where the opportunity to find mispriced securities is greatest. Most Wall Street analysts do not cover micro-cap stocks, and most investors avoid stocks with a tiny market capitalization because of the risks involved.

Still, it is very easy to find value in these parts of the market. Most micro-caps have little to no news coverage, so to gain any information, investors have to search SEC filings and really spend time conducting due diligence on the company.

As is usually the case with investing, however, the potential for increased returns comes with increased risk. As most micro-caps operate out of the public eye, there is more scope for them to commit fraud, manipulate stock prices and rip-off shareholders -- none of which are desirable outcomes for the investor.

With this in mind, here are three tips to help you avoid micro-cap value traps and frauds.

Follow the money

Without a doubt, one of the best ways to avoid company fraud is to pay close attention to cash flows. Profits on the income statment can be manipulated easily via aggressive accounting tactics, but cash flows are much harder to manipulate and are therefore likely to give a much more realistic view of a company's financial position.

What's more, if a company is generating cash from operations, it is less likely to be reliant upon capital markets for funding. If a company can fund itself, it is not at the mercy of creditors who can demand control of the business if things do not go according to plan.

Insiders know best

Insider dealing, or director dealing, can be a great indicator of what management thinks the prospects are for a company. It is important to determine the difference between director dealing undertaken to put on a show and dealing that is more meaningful.

If directors hold a stake in the company, but this position has been acquired via option grants, it is not really worth anything. The director has risked none of their own money to establish the position. If an insider uses cold hard cash to acquire shares of their company, this is a much more reliable indicator than shares acquired via option grants.

The value of the deal should be considered in relation to the purchasing director's salary. For example, if the director owns $1 million a year but has just purchased $10,000 worth of stock, the buying may be nothing more than a show to try and convince investors management is behind the business. A more meaningful acquisition of $100,000 or more is a more reliable indicator of director intentions.

Setting the price

The best business models are those where the business can set the price and consumers are willing to pay more for the product. Price setters include companies like American Express (AXP), IBM (IBM) and Coca-Cola (KO), three of Warren Buffett (Trades, Portfolio)'s favorites. These businesses have all withstood the test of time compared to price takers such as oil and shipping companies, which have struggled with low oil prices and shipping rates over the past three or four years. It has been extremely difficult to invest in these sectors since the financial crisis due to their lack of ability to set prices. If you want a good long-term investment, price setters are the way to go.

The bottom line

Used together, these three tips can help you avoid the worst micro-cap disasters. Nonetheless, I should point out they are not guaranteed to help you avoid disaster, but if a company meets all three criteria, it is more than likely you are on the right track to a sound investment. Further fundamental analysis should help you put together a solid investment case for the company in question.

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This article first appeared on GuruFocus.