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Gateway Industries might turn out to be the year's biggest gainer, but you probably shouldn't buy this stock.

Gateway's shares surged as much as 27,000% between Tuesday and Thursday, from just $0.02 a share to more than $5 per stub. The reason? Entrepreneur Robert Sillerman and partners decided to buy 120 million newly minted shares of Gateway, a nonoperating shell company, for $0.03 apiece. Sillerman will use the company, to be renamed Function (X), for his latest venture acquiring and developing new-media businesses. Previously, Sillerman founded CKX, an entertainment company that owns the American Idol franchise.

What might your hard-earned dollars buy when you plunk down money for this stock? It's unclear. The shell company has little more than the $3.6 million that Sillerman paid for the new shares, but has accumulated losses of some $12.6 million. Sillerman says, "Function (X) dwarfs the CKX opportunity by an order of magnitude." But what exactly is the opportunity?

Stock pumpers on Twitter and message boards are also saying little (except "buy the stock, you chump"), so nobody knows what's going on. But with shares trading around $2 right now, the company already has a market cap of almost $250 million. That's a recipe for disaster. What you're buying is unclear, and until investors know, they would be wise to stay away, notwithstanding Sillerman's interesting track record. He's sold previous businesses in the areas of radio and concert promotion for billions.

After the furor, shares plummeted quickly, sinking 37% Friday. The pumpers at Twitter are still at it, but the stock has been down another 30% today. It's a stock that could ruin your life: You have no idea how the company will make money or what assets it has. You're handing money over to an unknown management team, and you're just hoping for the best. Plenty of other public companies could ruin your life, despite their SEC filings. Enron? Worldcom? Let me give you a tip for finding these suspect companies.

A simple little trick
A quick and easy way to spot trouble early is to compare a company's operating cash flow to its net income. If operating cash flow is less than income, you should probably further dig into why. Low operating cash flow suggests the company is booking revenue well before it actually gets paid or that it might actually be loosening payment terms in order to win business, or worse. Such an easy test could have spotted Enron in 1997, years before it blew up.

But this litmus test isn't foolproof. There are legitimate reasons why operating cash flow might lag income, especially in any one year. Seasonality can affect results, too, and the analysis doesn't work well for some types of businesses, such as financials. But year after year of lagging is a serious warning sign. Let's look at some companies whose cash flow trailed net income over the trailing 12 months (TTM) and see how this simple test applies. The following small caps have been popular and offered the promise of massive opportunity, much like Gateway.


Operating Cash Flow (TTM)

Net Income (TTM)

Exelixis (Nasdaq: EXEL  ) ($173.1 million) ($103.3 million)
Yongye International (Nasdaq: YONG  ) ($4.7 million) $46.1 million
China Agritech (Nasdaq: CAGC  ) ($18.5 million) $7.0 million
Microvision (Nasdaq: MVIS  ) ($43.3 million) ($40.8 million)
Fuqi International (Nasdaq: FUQI  ) ($19.4 million) $48 million

Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months.

Yongye and China Agritech are peers in the Chinese fertilizer arena. At Yongye, cash flow trailed net income mightily over the last four quarters. In fact, it's the same situation over the last three years, but why might this be? A closer look mitigates this danger sign.

At a fast-growing company such as Yongye, whose sales are up more than 100% annually for the past two years, it's not unusual to see this discrepancy. In order to grow that quickly, the company has to invest heavily in inventory. The seasonality of the ag business can also make cash flow look lumpy, with receivables sucking in cash. But Yongye has had no trouble collecting those accounts. The company uses Big 4 auditor KPMG and Motley Fool Global Gains advisor Tim Hanson has visited Yongye's factory and tested its fertilizer products (they work!).

China Agritech's numbers are erratic over the last three years, with cash flow below income in two of those 12-month periods. Revenue has grown 40% annually over the last three years, but inventory growth doesn't seem to be requiring much cash, which is unusual, relative to Yongye. I'd want to know more about this discrepancy. The company is currently rebutting claims from LM Research that the company reported fictitious revenue, and the stock is down nearly 70% from its 52-week high.

Microvision ran net income higher than cash flow over the last year, but it's got bigger problems, with cash flow and income solidly negative. The company, which makes miniature projectors, has lost money every year in its 17-year history as a public company. A quick scan of income or cash flow would have kept you out of this.

Exelixis has seen erratic changes in cash flow over the last three years, but net income has remained firmly negative. Does that make it dangerous? Not that alone. Exelixis develops drugs that require years of expense before they're proven out, so in any given year cash flow and income might diverge. Take peers Isis Pharmaceuticals (Nasdaq: ISIS  ) and Human Genome Sciences (Nasdaq: HGSI  ) , where cash flow has bounced around higher and lower than income in the last three years. The more important question is: Do you believe in the company's drug pipeline and relationships with bigger players? If so, then discrepancies between cash and income are not really a concern.

As a maker of jewelry in China, Fuqi was popular recently, and the stock ran from less than $5 to over $30 in mid-2009. But the price has slowly bled back to $5 today. In the last two years the company's cash flow has run well below net income, and you have to go back to the 12 months ending in September 2007 to see cash flow topping net income. Last March, the company said that accounting errors led to it overstating income for the previous nine months, and shares fell around 35% on the news. In September, Nasdaq threatened the company with de-listing if it doesn't file its financial statements by March 28.

Foolish bottom line
Investing is often about protecting your downside as much as it is about finding rocket stocks. While this litmus test may screen out ultrafast growers such as Yongye, it can also protect you against the ruinous losses of a China Agritech or Fuqi. And if, after further digging, you find the company attractive, you can still buy. That's why I own Yongye, which trades at less than 7 times earnings, but is expected to grow profit at nearly 40% next year. I want high-flying stocks that can ride the China boom without the undue risk.

If you're looking for one fully vett ed stock investment in China, get The Motley Fool's free report "This Stock Is Set to Soar as China's First Global Brand Emerges."

Jim Royal, Ph.D., owns shares in Yongye. Exelixis is a Motley Fool Rule Breakers pick. Yongye is a Motley Fool Global Gains recommendation. The Fool owns shares of Exelixis and Yongye. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 15, 2011, at 5:56 PM, Merton123 wrote:

    Jim Royal good article. The enterprising investor can either make or lose money in the penny stock arena and pink sheets. How can the enterprising investor minimize risk in this sector? Pretend that the company is going private after you purchase it. This means that you are only buying the business because it pays high dividends. Yes "Value Line - small stocks" has several small caps which provide generous dividends. The Enterprising Investor really has to do her research to make sure that the company will continue generating the high dividend yield after it goes private. I have been following Motley Fool for a few months and haven't seen any articles about small caps stocks that generate high dividends. This could be a good niche for a newsletter

  • Report this Comment On February 15, 2011, at 6:00 PM, Borbality wrote:

    Merton: I think I just read a story about what you're talking about here a couple months ago. It says how the best stocks over the last 10 years started out as small-caps with dividends. It made me look at AFSI.

  • Report this Comment On February 16, 2011, at 3:19 PM, goldminingXpert wrote:

    I thought this article was about CAGC, which will ruin your life if Bronte Capital is right (and they probably are.)

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12/31/1969 7:00 PM
CAGC.PK.DL $0.00 Down +0.00 +0.00%
China Agritech Inc… CAPS Rating: **
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Exelixis CAPS Rating: ****
FUQI.DL $1.50 Down +0.00 +0.00%
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