Thankfully, it seems like many people (including even some institutional investors) don’t get it. With microcap stocks, it’s very important to examine the company’s general and administrative spending. The companies with excessive G&A spending are typically doing one or all of the following:
- Lining insiders’ pockets or supporting their lavish lifestyles (e.g. private jets, unusually expensive meals, etc.).
- Paying for stock promotion.
- Operating inefficiently.
All of these behaviours are bad for shareholders. Excessive G&A is a sign that at least one of these value-destroying activities is happening. Examining G&A will help you avoid stock promotions and really awful management teams.
If the company is spending millions on mineral exploration (most junior exploration companies do), you want to look at the ratio between G&A and exploration spending. If the company is spending 40 cents or less on G&A versus every dollar of exploration, they are somewhat efficient. It is a major red flag if the ratio is close to 1:1.
If the company is spending less than a million dollars on exploration, it is difficult/impossible for the company to perform well on this metric due to unavoidable overhead associated with a public listing. The big picture is that microcap business model in general is not a great one to begin with. Due to their small size, overhead will slowly eat up shareholder capital. (In the US, some non-mining companies avoid this by terminating their securities registration.)
Oil and gas
Look at G&A as a percentage of revenues. 10% or less is reasonable if the company has significant oil/gas production. Above 10% is a red flag.
Look at G&A versus R&D. For many pharma research companies, G&A is roughly a third or less of R&D. A 1:1 ratio is a red flag. If the company has at least a million dollars in revenue, then this shortcut won’t work because the picture is clouded by non-R&D G&A.
Investor relations, travel and entertainment
The financial statements for some microcap stocks will state how much money was spent on investor relations (almost always an euphemism for stock promotion) and “travel and entertainment” (which is probably supporting insiders’ lavish lifestyles). Sometimes they make things really easy to figure out.
If a microcap company is spending a million dollars a year on travel and entertainment, insiders probably aren’t flying coach or even first class. Insiders have to spend money extravagantly to rack up a bill that large.
Consultants paid in shares
This is a red flag. If you look at the work of paid stock promoters, there is often a disclaimer which states that they were paid in cash and/or stock. (Though not all promoters get paid in stock.) Sometimes, this behaviour shows up in the financial statements. The financials may mention (investor relations) consultants who were compensated in stock or stock options. This is often a sign that the company is engaged in degenerate forms of stock promotion.
When going through microcap stocks, I usually use the search function in my browser or PDF reader to look for the phrase “investor relations” in the financial statements.
Real world correlations
The most inefficient microcap companies tend to be the scummiest. They may engage in the most questionable forms of stock promotion (e.g. shills who don’t disclose their financial relationships, boiler rooms, etc.). The people behind them tend to use the company as their piggy bank. There is adverse selection at work.
Larger market capitalization stocks
Simple measures of G&A efficiency work less well because larger companies tend to have multiple business segments. This makes different companies in the same sector difficult to compare. For example, some oil companies are involved in marketing, midstream, oilfield services, and/or owning their own drill rigs while others aren’t. Nevertheless, analyzing G&A spending still makes sense. It just takes more work.
Chesapeake for example had a lot of wasteful spending. Some of it only came out after the fact. However, anybody could have figured some of it out from reading SEC filings. All sorts of wasteful and egregious spending by Aubrey McClendon was disclosed in Chesapeake’s DEF 14A filings.
(*Disclosure: No position in CHK.)
The bottom line
From a short selling perspective, looking at G&A efficiency is a time-saving trick that helps identify the worst companies. However, I do not believe that this shortcut is that effective at identifying efficient management teams or honest management teams. It is not as useful for long investors as it mostly only identifies the worst of the worst.
Here’s my post on performing due diligence in November 2013. I look back on it and realize that I have a lot more tricks now than I did half a year ago.