What Would You Sacrifice for Mind-Blowing Returns?

The American Stock Exchange (AMEX) recently announced plans to try and 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 face any AMEX stock they come across with a hefty dose of skepticism. As the exchange's chief regulatory officer, Claudia Crowley, revealed to Forbes last October, "25% of the stocks listed were exceptions to our guidelines."

And those guidelines were never too strict anyway. Now comes The American Platform (TAP), where any 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 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 necessarily lack appeal. Many of these stocks will be the proverbial lottery tickets -- undergoing huge price swings in short periods.

For example, nine companies doubled in the month of February. Every single one began the month capitalized at less than $200 million, with the largest being $182 million Valence Technology (Nasdaq: VLNC  ) , $66 million Encysive Pharmaceuticals (Nasdaq: ENCY  ) , and $20 million IDM Pharma (Nasdaq: IDMI  ) . The biggest large-cap gainers, on the other hand, were Mechel Open Joint (NYSE: MTL  ) , EOG Resources, and Chesapeake Energy (NYSE: CHK  ) -- which rose a "modest" 37%, 33%, and 20%, respectively.

But 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. Among the 10 best stocks of the past 10 years, nine began their runs as companies capitalized at less than $200 million.

Of course, many more failed along the way. So you have to be extremely careful when choosing among micro-cap candidates. This means carefully assessing a company's management and SEC filings -- and hoping that the exchange (cough*TAP*cough) does its job by delisting companies that don't present their 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 among Wall Street analysts and institutional investors. As a result, these stocks can have far bigger potential than the market prices into them. That's why Warren Buffett has said he could earn 50% annually if he invested in small companies, and why 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 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 on the lottery tickets that may find a home on 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.

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

Tim Hanson does not own shares of any company mentioned. Chesapeake Energy 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.


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