Nanocaps: why I don’t like them

Nanocaps are stocks with a market cap less than $50M.  (To be honest, I used to think that the correct term was microcap.)

There are two main reasons:

  1. The overhead of being a publicly-listed company is going to be a huge drag on performance.
  2. Often these stocks are intentionally created knowing #1.  The brokers know that shareholders will have a hard time making money but they don’t care.

Overhead

Publicly-traded companies have the following expenses related to their public listing:

  1. Compliance.  You need a CFO/accountant to handle all of the regulations associated with a public listing (and there are a lot of them).
  2. Audit fees.  Disclosed in DEF 14A forms for US stocks and in the Management information circular on SEDAR for Canadian stocks.
  3. Board of directors.
  4. Listing fees.
  5. Transfer agent fees.
  6. Liability insurance for company insiders.  Some companies pay for this because management may do sketchy things that shareholders (or lawyers) may sue them for.  If a company pays for this, it is probably a red flag.  Good management teams don’t do shady things and have no need for such insurance.

These costs will range from company to company.  Some companies pay more for audit fees even if their audit is simpler than other companies.  The compensation of directors varies widely.

Let’s suppose that all these overhead costs total $200k (sometimes it is a lot more).  For a $4,000k market cap company, you have 5% of “assets under management” being spent on overhead associated with a public listing.  This is a huge drag on performance.

These stocks tend to be shady

There are brokers that consistently sell these nanocap stocks to investors so that they can collect underwriting fees.  They’ve been doing it long enough to notice that their clients lose  money on these stocks.  Oh, they know.  But they don’t care and their clients want to gamble.  These stocks aren’t about making money for shareholders.

A lot of CEOs who run these nanocaps are about making money for themselves.  It’s rare for them to have skin in the game.  And if you have skin in the game, you will quickly realize that you need to grow your company quickly to outrun the burden of the company’s overhead costs.  Stocks like Contango Oil & Gas, Northfield Capital, and Altius Minerals started out as nanocaps.  These stocks are the rare exceptions and I probably would not invest in them in the very beginning.

Penny stocks

Penny stocks are stocks trading at less than $5.  The share price actually matters due to (1) stigma/perception, (2) regulations, and (3) rules imposed by brokers.

There are often restrictions on owning stocks under $5.  You can’t margin them much, there are short selling restrictions, some institutional investors simply aren’t allowed to own them (because penny stocks are shady), etc. etc.

Most nanocap stocks are intentionally priced under $5.  They do not use (reverse) share splits to reach a normal price.  The low share price creates the impression that the stock can go up a lot.  It also inhibits many short sellers from shorting the stock (most of these stocks are headed to zero so they are attractive to short sellers).  Keeping the share price under $5 will reduce the amount of short selling pressure.

Stocks that are intentionally priced under $5 have some of the same problems and underlying drivers as nanocaps.  It’s no surprise that most nanocaps are penny stocks.

Special situations spinoffs

Nanocap spinoffs like AAMC could be worth pursuing.  (Though currently the valuation on AAMC is absolutely ridiculous.)  Nanocaps are extremely unattractive to institutional investors and they may blindly sell them.

I do not own anything like this currently.

Disclosure: I may be an idiot

I own nanocaps.  I own KWG Resources ($33.51M market cap).  I own Northfield Capital and Altius Minerals, companies that are invested in nanocaps.

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