With two of the major indices at all-time highs and the third (Nasdaq) nearing striking distance of its all-time March 10, 2000 high, investors find themselves scratching their heads looking for potential 4-baggers, or even humble doubles. In one of my recent interviews, a notable fund manager indicated that he felt that 2014 would be the year of the smallcap stock. There are good reasons behind that expectation.
First of all, there are thousands more smallcap stocks than there are midcap and largecap stocks combined, which means that a careful screen could turn up some surprising values. Keep in mind that most smallcaps have no research coverage, so any analytical work either has to be derived from the company's own guidance and publications, or it has to be time-consuming - or if you're lucky, it could come to you on a telephone call from a friend.
They're all over the place industry-wise, and that's one of the problems, because if you're accustomed to investing in, say, homebuilders or Greek shipping companies or oil & gas companies, or fast food or retailers, you probably would pass right by someone outside your bailiwick -- a life insurance company, for instance. After all, their financial reporting is different from companies that sell widgets or services or hamburgers, and the small ones can be well hidden in the low-trading category.
Take Security National Financial (NASDAQ:SNFCA), for instance. It's small and difficult to understand, headquartered in Utah, and at first glance appears to most people to be a mortgage company that owns some cemeteries and mortuaries on the side (it's not; it is a classic life insurance and reinsurance company). To make matters worse, most of the internet information sites have calculated the market cap spectacularly incorrectly, which I suspect is a problem that is lodged in the craw of one of McGraw Hill's divisions or some other information vendor. For some arcane reason, this little company issued two classes of stock years back - the A stock trades in the public, and the C stock is entirely owned by insiders. The two classes of shares are approximately equal in terms of numbers issued and outstanding. So most people multiply the number of shares contained in both classes by the stock price to get the market cap. Seems simple, right?
But it's wrong. The C shares each have one common vote, but they only have 10% of the equity ownership of an A share. In other words, if you wanted to trade your C shares for A shares, you would only get 10 shares for every 100 you own. And since there is no market for the C shares, it is conceivable that over a period of years, the C shares will diminish in number anyway. But the important part for today's investor is that the formula for the market cap is A + C/10 multiplied by the stock price. As far as I can tell, Yahoo Finance is the only one of the standard information sites that has the market cap right. Both Google Finance and Bloomberg calculate it wrong - very wrong. And the Bloomberg error will knock most Wall Street pros out of the box on this one.
Now who's gonna find that? Answer: very few people. So the stock barely trades, and institutional investors shy away from it because they could get trapped. If word were to get around, it could be an easy double, because the portfolio value dwarfs the "real" market cap. I won't do the math here. I'm not an investment advisor, and you can figure it out for yourself, because it's very simple.
Or look at Atlantic American Corporation (NASDAQ:AAME), headquartered in Atlanta. On a good day it trades less than 10,000 shares. On a bad day it can trade the proverbial goose-egg. It is an insurance holding company with a market cap in the range of $88 million, and its operating subsidiaries are highly rated by AM Best, which is one of the gurus of the insurance business. It pays a cash dividend, and reported a boffo June 30 quarter this year, but like a tree falling in the forest, it was hard to tell whether anyone heard the news. Their entire institutional holdings come to less than 5% of the shares issued and outstanding. Again, I'm not going to do the math, but look at the PE, the yield, or the market capitalization, all of which are paltry compared to whatever you like to look at as a metric. And imagine what would happen if a few institutions decided to own a piece of this tasty little pie.
There are hundreds of these neglected little companies, nowhere more than in a category of security that most investors - even institutional investors - fail to understand: American Depositary Receipts or ADRs.
For anyone who is unfamiliar with ADRs, they are effectively tradeable shares of foreign-based corporations that usually are not required to report to the SEC on any basis other than what they are required to do on their home exchange. Twice a year? OK. Report in rupees? OK. GAAP? OK. Non-GAAP? OK. Sounds like the Wild West, doesn't it? But it's not, or at least not entirely.
Some of the largest companies in the world trade are represented in the US markets by ADRs, and more often than not, those ADRs are quoted at the very bottom of the market food chain, on the Pink Sheets or one of the fancied-up OTC markets like the OTCQX, which was cleverly modeled by OTC Markets as a combination, more or less, of the UK's AIM and possibly the Borsa Italiana's STAR segment (both of which are now owned by the London Stock Exchange). OTCQX companies agree to some reporting standards that are not required of OTCBB, OTCQB, or Pink Sheets companies. OTCQX companies are also required to have an American advisor - either from an investment or depositary bank, or from another type of expert firm, like a securities law or accounting firm - to keep them on the straight and narrow, and to vouch for their continued eligibility for the OTCQX.
Here's the rub. Most ADRs don't trade very well unless they are well-known "brand names." So Fiat (FIATY) and chemical giant BASF (OTCQX:BASFY) trade just fine. On the other hand, the huge Brazilian creditcard clearinghouse Cielo SA (OTCQX:CIOXY), which trades millions of shares a day in Brazil, only trades a couple of hundred ADRs a day, in spite of its mind-boggling growth and results. All ADRs tend to follow the "home exchange" in valuation, so the ADR will be very close to the same price, given currency differences, as the Fiat price in Italy or the BASF price in Frankfurt. Arbitrage is not the reason to buy ADRs, in other words.
The reason to buy ADRs is that they are denominated in US dollars, and they can be deposited in DTC, the Depository Trust Company, which is the "vault" that most US brokers use to keep their stocks safe. The Fiat shares in Italy cannot be deposited in DTC, so if you buy them, your broker basically has to keep them in the back room, and then find a value in euros and convert it to US dollars to send you your statement. And your foreign shares are probably not marginable (but the ADRs are).
One way to look at ADRs is as a service, not a security. You can buy a bunch of shares in the UK soft drink giant, Britvic, in London, for instance, and instruct your broker to convert them to the Britvic ADR (OTCQX:BTVCY) at no charge. Then they can go into your account and act just like US stocks in terms of valuation and possibly margin (depending on the rules at your brokerage) - and if you want to sell them they can be reconverted back to LSE shares in the twinkling of an eye and sold whenever you want them to be sold.
There are two issues to remember though. First of all, there are ADRs that end in Y and ADRs that end in F. Some companies have both. Big difference. The ones that end in Y are "sponsored," which means the company in question is backing them, and they are officially US securities, with the underlying securities in the vault of one of the four "depositary banks" (Bank of NY Mellon, Citi, JP Morgan, and Deutsche Bank). The ones that end in F are "unsponsored," which means they are simply a mask quoted in US dollars for the foreign stock, and if you buy them they settle on the foreign exchange. So if you buy BTVCF (the F version of Britvic), you are going to settle in pounds sterling, not in US dollars, and your shares will not be acceptable to DTC. That's item number one - stay away from the ADRs that end in F unless you can cope with foreign-currency shares.
The second issue to remember is that many smallcap ADRs barely trade. Some will have average daily volumes under 100 shares; some will have zero. You can ignore that, because it has no real effect on you. What you have to do is look at the trading on the home exchange. The Norwegian high-flier, Opera Software ASA, trades nearly 320,000 shares a day in Oslo, but their ADR (OTCPK:OPESY) only trades 200 or so shares a day. If you want to buy Opera shares, instruct your broker to buy them in Oslo, convert them to ADRs and throw them into your account. And when you want to take profits or minimize losses - sell them, in other words - you do the reverse. It may take minutes longer, but for most normal investors that simply doesn't matter.
You can find lists of ADRs on the Internet. Some are traded on the NYSE or Nasdaq - and those companies are subject to the full rigor of SEC regulation. But far and away the majority are quoted (not listed, mind you, just quoted and traded - there is a difference) on the Pink Sheets or the OTCQX, both of which can be found at www.otcmarkets.com. Because of the nature of regional exchanges and many foreign exchanges, investors can find a lot of bargains in the ADR lists - companies that are growing fast, that are selling for low multiples, that have undervalued assets on their balance sheets. Many of the smallcap ADRs (especially those in healthcare or consumer products) may eventually trade the majority of their securities in the US, because the US is where the majority of their business is or will be.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.