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What Would You Sacrifice for Mind-Blowing Returns?

The American Stock Exchange (AMEX) recently announced plans to try to become the exchange for micro-cap stocks. Forgive me if I run screaming from the building.

Why? Well, the AMEX is the least reputable of our major U.S. exchanges. It lists more than its share of questionable companies, and it has a long history of not delisting companies when it should. In other words, investors would be wise to regard any AMEX stock with a hefty dose of skepticism. As the exchange's chief regulatory officer Claudia Crowley revealed to Forbes in October, "25% of the stocks listed were exceptions to our guidelines."

And those guidelines were never too strict anyway. Now enter The American Platform (TAP), where a company will be allowed to list so long as it has a $50 million market cap and $4 million in shareholder equity.

Here's the problem with that
While the AMEX sees TAP as a "farm system for micro-cap stocks," I see a haven for penny stocks and pump-and-dump schemes. And the AMEX doesn't necessarily disagree. Here's what AMEX CEO Neal Wolkoff told Forbes: "I'm not holding out TAP stocks as the creme de la creme, because they're not. That doesn't mean people should not be allowed to buy them."

I'm all for investor freedom, but the companies I foresee being listed on the TAP will be accorded a degree of credibility (thanks to their listing on a major exchange) that they likely won't deserve. Yet they won't be without appeal. Many of these stocks will be proverbial lottery tickets -- undergoing huge price swings in short periods of time. For example, 37 stocks have at least doubled since the beginning of July. Just three -- China Southern Airlines (NYSE: ZNH  ) , Yingli Green Energy (NYSE: YGE  ) , and DryShips (Nasdaq: DRYS  ) -- have achieved that performance off a market cap of more than $1 billion. The other 34 started as tiny, tiny companies.

Here's the thing about micro caps: If you buy shares of the right ones, you will earn the best returns our public markets have to offer. Of the 10 best stocks of the past 10 years, five of them began their runs as companies capitalized at less than $50 million.

Of course, many more failed along the way. So you have to be extremely careful when choosing among micro-cap candidates. This means doing a careful assessment of a company's management and SEC filings -- and hoping that the exchange (cough*TAP*cough) does its job to delist the companies that don't present financial information in a forthright and timely manner.

Why you should bother with small caps anyway
Besides the big returns, another advantage of investing in small companies is their paltry following from Wall Street analysts and institutional investors. As a result, these stocks can have far bigger potential than is priced in by the market. For this reason, Warren Buffett has said that he could earn 50% annually if he invested in small companies, and David Nierenberg focuses on micro caps at his market-crushing D3 family of funds.

But Nierenberg, for one, isn't taking a flyer on questionable $50 million firms. He defines micro caps as any stocks capitalized at less than $1 billion. Given that Wall Street analysts are covering fewer companies than ever before, you can gain the micro-cap advantage without risking your savings in those $50 million lottery tickets that will find a home on the TAP.

More pieces to the puzzle
At our Motley Fool Hidden Gems small-cap investing service, we believe we can gain an information advantage when it comes to companies capitalized at less than $2 billion. We seek strong balance sheets, high amounts of insider ownership, and businesses that generate actual cash alongside GAAP earnings. By doing so, we uncover fantastic small businesses that are being built to last for decades. Historical examples that fit this profile are some of the markets' biggest success stories: Nike (NYSE: NKE  ) , Wal-Mart (NYSE: WMT  ) , and Wendy's (NYSE: WEN  ) , for example.

And the methodology continues to work today. Our recommendations are ahead of the market by nearly 40 percentage points to date. You can see all of our research and recommendations, as well as our picks for new money now, with a 30-day guest pass to the service. Click here for more information.

This article was first published on Mar. 30, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Wal-Mart is a Motley Fool Inside Value recommendation. The Fool's disclosure policy, without asking why, will show you the way to the next whiskey bar.

Read/Post Comments (1) | Recommend This Article (2)

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  • Report this Comment On October 21, 2007, at 1:10 PM, xzqx wrote:

    FWIW, i work in the financial industry, and AMEX is also well-known for being the least reliable exchange wrt electronic availibility and market data. in other words, if an exchange stops listing on a busy trading day, or is unable to fill trades, it's probably AMEX! So this is not very surprising.

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