I have a problem. I was born with the skeptic's gene, and an oversized appreciation for truth and fair play. Yes, that makes me absolutely no fun at cocktail parties, but in the stock market, it can be very beneficial. That's because an enormous percentage of what occurs out there in the "investing" world is nothing more than slick liars looking for trusting rubes in order to separate them from their wallets.

Here's why.
I was recently delighted -- though surprised -- to see that the alleged perpetrators of what looks like a particularly brazen scheme at a company called Pegasus Wireless have been called to justice, at least partially. There's a civil case being pushed by the SEC alleging $30 million worth of stock fraud. Let's hope there's a criminal case coming as well, because I think that if anyone deserves to be in the federal pen, it's those responsible for Pegasus: CEO Jasper "Jay" Knabb and CFO "Ferrari" Steve Durland.

Pegasus Wireless, a few years back, claimed to be a leading producer of networking devices on the road to great things. Despite having no track record and a competitive landscape that included Cisco (NASDAQ:CSCO), Netgear (NASDAQ:NTGR), Microsoft (NASDAQ:MSFT), this upstart manufacturer, with nary a product on store shelves, even claimed to be out to undo Apple (NASDAQ:AAPL) in the delivery of rich media to linked devices like high definition TVs.

I detected the strong scent of the backside of a bull, and wrote article after article detailing the utter improbability of the story, the awful financials, but most importantly, the penny-stock, pump-and-dump background of the two men running the show. Many investors didn't listen ... at first. The company's market cap soared above the $1 billion mark.

Eventually, however, shares dropped, even as Knabb crafted a PR blitz (using gullible Forbes writer Liz Moyer to publicize his bogus claims) blaming naked shorts for declines in the stock. He also tried to foment a short squeeze, which was the tip-off for me that this winged horse had to be lame.

By the time Knabb claimed to have taken the operation to Grand Bahama, the jig was up, and it was all over but the enforcement, which is finally upon us.

Scammy is as scammy does
Of course, Knabb's claims for his products look particularly brazen in hindsight -- though things obviously weren't so clear to the investors who were duped. There were plenty of people who believed the story, and had neither the time nor inclination to dig further. And while uncovering the red flags at Pegasus was relatively straightforward, unfortunately, in the small-cap world, it's not always that easy to spot the problems that might just up-end your investment thesis, and empty your wallet.

These days, I don't have as much time for the scam-busting. As co-advisor of Motley Fool Hidden Gems, however, I never forget the lessons that a Pegasus Wireless can teach. For me, the quickest way to flag the potential scams is to:

  • Run at least minimal background checks on your CEO, CFO, and board Chair. If it's a micro-cap stock, this is a necessity. Check the fate and financials of their previous companies, because failures tend to keep failing, and scammers always return to try and scam again.
  • If management or the company's investor relations engages in public criticism of short sellers or attempts to manipulate their own share price, run -- don't walk -- away.
  • Disbelieve the claims of upstarts with "disruptive technology" until you see the money.
  • Watch free cash flow, not hyped-up individual sales contracts, revenue growth, or accounting earnings, which can be easily manipulated to give the illusion of growth and profits.

But this isn't just a good way to avoid junk or find short ideas. Some of my favorite ideas originally struck me as ludicrous, had-to-be scams. Running them through the same battery of quick skepticism proved them to be worthy of consideration. Jinpan International (NASDAQ:JST) and Dynamic Materials (NASDAQ:BOOM) were two companies I found this way. (Turns out both of these companies are making the most of big opportunities in traditional energy production, as well as alternatives.)

Hit 'em again. Harder.
Once a company makes it past your preliminary BS detection systems, you ought to subject it to a repeated battering, preferably over a few weeks time. The hotter the story, the more you should try to bash it, shred it, or pour ice water down its shorts. If you can't come up with a bear argument on your own, call up the most difficult friend you have, the one who hates everything (maybe the sullen guy with the goatee who ruins the kickball league with his negative attitude) and talk to him about it.

At Hidden Gems, since we're putting The Motley Fool's hard-earned money into a portfolio of small caps, we come across plenty of hot stories that need bashing -- especially because we begin watching many of these companies when they're still micro caps. Once a company is on our radar, we really dig in. We run each through batteries of financial tests, create cash flow models, pull them apart in hard-nosed committee discussions. Any stock that makes it into our buys has been through all this, and subject to at least two dedicated "bear maulings."

Foolish final thought
If you follow a similar process, I'm not saying you'll never get taken, or that you'll become the instant millionaire -- sorry, I can't make those kind of promises. But you'll greatly improve your odds. And not just with small caps. How much could investors have saved by being more critical of Countrywide Financial -- now part of Bank of America (NYSE:BAC) -- when Angelo Mozilo was dumping some $140 million dollars worth, instead of waiting for the crash? That was another pretty obvious tipoff of a doomed investment, but sometimes all you need is the obvious. You just need to look, listen, and consider it. Listen to your skeptical side. Your portfolio will be glad you did.

If you'd like some help finding thoroughly vetted small caps, you can check out the research and recommendations from our Hidden Gems real-money portfolio, free for 30 days. Click here to get started -- there's no obligation.

Seth Jayson is Co-advisor at Motley Fool Hidden Gems. He owns shares of Jinpan International, but has no position in any other company mentioned here. Dynamic Materials and Jinpan International are Hidden Gems recommendations. Apple and Netgear are Stock Advisor selections. Microsoft is an Inside Value pick. The Fool has a disclosure policy.