What Would You Sacrifice for Mind-Blowing Returns?

Editor's note: A previous version of this article incorrectly included Oncothyreon in the list of companies that doubled in December 2007. We regret the error. 

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 face 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 comes The American Platform (TAP), where a company will be allowed to list as 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, and while the effect the pending AMEX-NYSE Euronext merger will have on TAP remains to be seen, 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 be without appeal: Many of these stocks will be the proverbial lottery tickets -- undergoing huge price swings in short periods. For example, four stocks doubled in December. Every single one of them began the month capitalized at less than $220 million:

The biggest large-cap gainers that month, on the other hand, were Hess (NYSE: HES) and Mosaic (NYSE: MOS) -- which rose a "modest" 35% and 31%, 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. Of the 10 best stocks of the past 10 years, nine of them 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 doing a careful assessment of a company's management and SEC filings -- and hoping that the exchange (cough*TAP*cough) does its job delisting the 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 that they're underfollowed by Wall Street analysts and institutional investors. As a result, these stocks can have far bigger potential than is priced in by the market. It's for this reason that 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 in the lottery tickets that may find a home on TAP.

More pieces to the puzzle
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This article was first published on March 30, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Sun-Times Media is a Hidden Gems Pay Dirt recommendation. NYSE Euronext is a Rule Breakers selection. The Fool's disclosure policy, without asking why, will show you the way to the next whiskey bar.