What Are MicroCaps?

Your inbox is littered with them: newsletters alerting you to microcap stocks that are "Up 92% in one day!" or promise "1000% + gain on this one!" Some microcap scams are obvious, but others are not. Do you know how to identify a scam?

The siren call of wild returns from microcap stocks can be hard to resist. With approximately 15,000 publicly traded securities in the United States, most investors know there are many overlooked and misunderstood smaller companies worth owning. But investing in microcaps can be a minefield unless you know how to recognize real opportunity from fraud.

How MicroCaps Trade

The term "microcap" refers to companies with low or "micro" market capitalizations. These are companies typically ranging between $50 million - $300 million in market capitalization. Microcap companies primarily trade on the Over-the-Counter Bulletin Board (OTCBB) or the pink sheets.

The OTCBB is an electronic quotation system that displays real-time quotes, last-sale prices and volume information for many OTC securities that are not listed on the Nasdaq or other major securities exchanges. Although the NASD oversees the OTCBB, the OTCBB is not part of the Nasdaq. Scam artists often claim that an OTCBB company is a Nasdaq company, but this is misleading; it suggests that a company is larger and more liquid than it probably is. The pink sheets are named for the color of paper on which they've historically been printed. Many stocks quoted on the pink sheets are "penny stocks." Pink sheets are not a stock exchange and are unregulated.

What's Different About MicroCaps?

We all know that good information is an investor's best defense when purchasing shares in any company, but accurate information on microcap stocks can be hard to come by. Many microcap companies don't file reports with the Securities and Exchange Commission (SEC), so it's tough for investors to get all the facts. Lack of reliable information makes it easy for investors to be seduced by scam artists.

Another important difference between microcaps and larger stocks is the lack of minimum listing standards. Companies that trade their stocks on major exchanges, like the NYSE and the Nasdaq, must maintain minimum amounts of net assets and minimum numbers of shareholders to retain their listings. Companies on the OTCBB or the pink sheets, however, do not have to meet any minimum standards.

MicroCap Risks

It should come as no surprise to learn that microcap investing is far riskier than investing in large caps. Liquidity is usually limited, meaning that you might not be able to sell a microcap stock quickly enough to minimize losses when things go wrong. Earnings are often negative, and sizeable deficits may have accumulated. These companies are like shooting stars; they can fizzle out just as fast as they can light up the sky.

If you're researching a microcap stock, check the EDGAR database first, because even the smallest companies may file financial statements with the SEC. Companies with less than $10 million in assets actually don't have to file, but they often do if they want to offer their securities to the public. Other microcaps may offer publicly traded securities, but are exempt from filing with the SEC. These exceptions include "Reg A" offerings in which the company is raising less than $5 million in 12 months, or "Reg D" offerings, those raising less than $1 million in 12 months.

Phony Facts and Tools of the Trade

Microcap scammers rely on the lack of public, reliable information to spread phony facts. Which are their favorite tools of the trade?

  • Email: Junk mail and "spam" over the internet are favorite tools scam artists use to spread false information about microcap stocks. Never buy a stock based on an email from someone you don't know.
  • Internet Bulletin Boards: Many scam artists hide or change their identities in investor chat rooms or message boards, then use these forums to promote certain microcap companies. They often claim to have unique, inside information about a company or its products. Never buy a stock unless you've done your own research and verified the facts.
  • Paid Promoters: Some microcap companies pay promoters to recommend their stocks. These hired guns claim to provide independent, unbiased investment newsletters, research reports, and radio or television shows. Investors should check the credentials of anyone who declares his or her advice is objective and independent. Look for legitimate financial certifications that require holders to adhere to an ethical code (for example, a CFA, CFP, CIC and the like).
  • "Boiler Rooms" and Cold Calls: Some dishonest brokers organize high-pressure salespeople into groups (also called "boiler rooms") to make cold calls to potential investors and dupe them into buying questionable microcap securities. Be wary of calls from strangers and never give a cold caller your banking information or Social Security number.
  • Questionable Press Releases: Press releases can look real, but are you sure the company's sales, projections and products are valid? Check the facts on your own.

Microcap scammers use their tools of the trade to snare you in their net in the following ways:

  • "Pump and Dump" Schemes: Using Internet bulletin boards, chat rooms and telemarketers, scammers will use a pump and dump scheme that has them talk up a stock with claims they know something the rest of the market does not. Once they've hyped the stock enough to "pump" up its price, insiders and paid promoters will then "dump" their shares, causing the price to plummet and innocent investors to lose money. In a recent variation of the "pump and dump" scheme, some investors may discover a voice message, presumably left inadvertently on their answering machine, leaving a hot stock tip. Never trade on this kind of information.
  • Offshore Schemes: Under "Regulation S," companies that sell stock outside the U.S. to offshore investors don't have to register shares with the SEC. In an offshore scam, unregistered Reg S microcap shares are sold at discount prices to scammers, who in turn pose as foreign investors re-selling their shares to U.S. investors at inflated prices, pocketing huge profits. The flood of unregistered shares in the market invariably causes the stock price of the company to drop, resulting in major losses for unwitting investors.

What to Do if You Get Caught in a Scammer's Net

Report it! Start with your broker. If your broker can't solve the problem, you may want to contact your state's securities regulator or the SEC. Complaints can be filed online with the regulators. Don't let scammers turn you into a statistic. You'll succeed at buying small and winning big if you do your homework and watch for red flags.