How to eliminate "bad" microcap companies

I remember reading an account years ago of how the Secret Service trained their agents to identify counterfeit money.  The agents are never shown fake money, but intently studied real bills.  They spent hours studying bills and memorizing what a real bill looked like.  Once the agent had memorized every aspect of a real bill they could identify when bill differed in any way and know it's counterfeit.  It's a very interesting approach, and has some applications for investors looking for potential investments.

There are a lot of investors spending their time reading and looking at "good" companies.  These are usually success story companies such as Coke, Proctor and Gamble, anything Buffett has invested in, compounders (before they blow up) etc.  In theory if one had memorized the characteristics of a good company then identifying something that's not good should be easy.  And I think in many cases this is probably true.  If you spend your time studying good companies you will be able to identify something that isn't good.

Where investing and counterfeit training differ is the Secret Service knows what good means.  There is a standard of good, a bill that adheres to the Treasury specifications.  In the world of investing we don't have a standard like that.  What makes a good company?  Is it a company that compounds at high rates of return internally?  One whose shares appreciate so significantly that investors put the ticker on their license plate?  The largest companies? Innovative companies?  "Good" can mean anything, and it's different for every investor.

I don't spend my time looking at good companies, I've taken a different approach to my investing.  I look for bad things in companies, and when I find a company with either an acceptable level of bad, or no bad then I'll invest.  I find it easier to turn over rocks and eliminate the bad ones rather than hunting for the gemstone.  The difference can be described in an analogy.  Instead of picking through the fruit at the supermarket looking for a perfect apple, I'm looking at all of the apples and just trying to find ones without imperfections.  Some without imperfections might taste worse than others, but I'm not going to spend the afternoon comparing the firmness of every apple trying to find the best one.

This week I spent some time on OTC Markets looking through all of the recently released financials.  I used to do this weekly, but the habit has since fallen off for reasons you'll understand in a few minutes.  All I did was open each financial report, skim it for imperfections or items I don't want to deal with and move on.  In the past I could usually find a company worth further research with this method.  But this week I went through 12 pages of filings and just looked at junk, junk, and more junk.

It occurred to me as I was going through these junky companies that other value investors dipping their toes in the micro cap waters might want a bit of help on what to avoid.  This is not an exhaustive list, but I haven't been served wrong so far by avoiding companies with the following attributes either.

Constant share dilution or preferred stock issuances

In many small company annual reports there is a section towards the top detailing the capital structure.  There are a number of these companies that have lists of issuances dating back years, or preferred stock outstanding that is iterated into the N's, O's and P's of the alphabet.  If you see this move on.  The company is surviving on outside investor capital.  You are their business model.

Companies paying for services in stock

This is usually closely tied to constant dilution, but sometimes it isn't.  Equity capital is the most valuable capital a company can have.  If management has determined that they're willing to hand out shares to newsletters, ad agencies and websites for the equivalent of a Google Ad mention it gives investors good idea of how valuable management believes their shares are.  If management treats their equity like toilet paper then the equity is probably as valuable as toilet paper.

A Nevada incorporation

The State of Nevada is notorious for how easy it is to setup a business.  A few forms and a check and you're on your way.  They're also notorious for having the fewest protections for shareholders.  There are legitimate companies with Nevada charters, but they are few and far between.  If you find a company suddenly went dark with your investment you won't have the right to look at the books unless you own a significant and potentially controlling interest in the company.  This isn't true for other states where a single share grants you legal rights.

Constant name changes

When a business formerly named "Southern California Hot Dogs" changes their name to "BioHealth Sciences" and then "EcoWater Tech"  you know you have a winner on your hands.  Companies like this usually have a world changing invention that they refuse to demo as well.  Avoid companies that use "enterprises" in their name, or ones that have faux fancy names.  "The Park Avenue Warehouse Holdings" sounds fancy until you see they're located in Des Moines, Iowa and they own Wendy's franchises.

Annual reports that appear to be copy and pasted from Excel

Maybe this is a minor nitpick, but it's a pet peeve of mine.  There are companies that either take screen shots, and yes they're sometimes blurry, of their financials and paste them into the annual report.  Or outright copy and paste them, with cell borders and all into the annual report.  It strikes me as lazy.  That the CFO couldn't spend an additional two minutes removing the cell borders, or cleaning up the sheet.

Closely related to this item are annual reports in goofy fonts.  If a company's annual report looks like it was typed up by a 13 year old in comic sans for their art history class you need to run, not walk from that company.

Conclusion

As I said earlier this isn't an exhaustive list, but these are some items that I kept seeing as I looked at pink sheet companies.  I mentioned earlier that I wasn't able to maintain my habit of weekly reviews of every company that filed.  You might be wondering why.  The reason is companies worth additional research started to become too few and far between.  In the past I could spend a few hours looking at names and walk away with one or two prospects for further research.  Now I just spend hours ending up empty handed and wondering if I just wasted a lot of time.

There are a lot of companies that trade over the counter, there are thousands of them.  There is no reason to fill a portfolio, or even let in one or two companies that have glaring issues such as the ones I detailed above.  Maybe a company or two that exhibits some of these characteristics will buck the trend, but more likely investors will be marking the investment as a tax loss.