Ian Cassel's  Instablog

When deciding to invest in a micro cap stock, the most important thing outside of a company’s business itself is their share structure. I’m not going to go into too much detail, but there are certain elements which are crucial to understand before making an investment. The elements of a share structure that I pay careful attention to are outstanding shares (OS), fully diluted outstanding shares (FD OS) which include options and warrants (in and out of money), insider ownership, and convertible preferred shares. A company’s share structure is a complete reflection of management’s ability to create shareholder value. Management’s #1 goal should be to get off the OTC bulletin board, and a company’s share structure is usually the main deterrent or facilitator. 
 

OS and FD OS: These two terms are highly important because they are the key component in deriving a company’s market cap.   The OS can always be found in quarterly and annual reports, 10Q’s and 10K’s or by calling the company’s transfer agent. The FD OS can be found by taking the OS + warrants/options + convertible notes/shares. Also, I add all the warrants and options including “In the money” and “Out of the money”. If they add dilution they are getting added. The most detailed account of options/warrants is always found in the 10K (annual report) usually buried way down in the report.   Make sure that when you are adding up a company’s FD OS you pay careful attention to any outstanding preferred shares/convertible preferred shares. Many preferred shares have a conversion feature that convert into common shares at some ratio. For example, company XYZ might have 100,000 preferred shares outstanding which seems small so you don’t pay attention to it, but in reality they may convert 1:100 into common shares. In other words company XYZ’s FD OS is actually 10 million (100,000 preferred shares x 100) shares more then what you thought. Always use FD OS when evaluating a stocks market cap and while doing EPS and PE analysis.  
 

As an investor my sweet spot is between 10 million – 60 million FD OS. I normally don’t look at anything outside those parameters unless there is absolutely no financing risk and/or the fundamentals warrant it, as in Electronic Game Card Inc’s (EGMI) case {62m OS outstanding, 70m FD OS}. ZAGG Inc (ZAGG) fell right in the sweet spot {20m OS, 25m FD OS}. The reasons for not getting involved with companies with high FD OS’s are obvious. If company XYZ has 200 million OS and the stock is at $0.50/share it already has a market cap of $100 million. You know how much money a company with 200m shares out has to make to make 0.10 EPS thus warranting $1-2 stock price? $20 million, Good luck but I’ll pass.   However, a company like ZAGG only has to make $2.5 million net to make 0.10 EPS. Other reasons to stay away from high FD OS stocks are that it takes a lot of volume to move them and each incremental move higher has a much bigger effect on market cap.  For example, ZAGG going from $4 to $8, is the same as company XYZ going from $0.50 to $1 when looking at market cap. More importantly, a company trading under a buck with 100 million+ OS just shows that management either didn’t do their job or isn’t doing their job. A point I made earlier is that every CEO’s #1 goal should be to get off the OTC Bulletin Board and quite honestly it won’t happen with a high FD OS companies.    
 

ZAGG Inc really was a perfect situation. I found the stock in October 2008 during the economic crisis. At the time the company was at $0.60/share, trading 18,000 shares a day on average, and had a market cap of $15 million (25m FD OS x .60). Up to this point the stock was in a trading range of 55c – 90c over the prior year. The company just reached an inflection point ie profitability and announced the product entering Best Buy (BBY). ZAGG’s run up in recent months was only attainable because of the tight share structure which I found to be a great reflection on management.  Between October-December 2008, I and few other investors bought up every share we could since I thought this was a $3 stock in the making. With only 25 million FD OS and 6-7 million shares in the float there came a point in time where the scarcity of shares and the 100% net income growth lead to high PE multiples {Disclosure: also signed onto be an advisor to ZAGG in December 2008}. My point being that a stock with a good share structure like ZAGG will always trade at a higher multiple (PE) due to the scarcity of shares, when compared to the same business model inside a company with 200 million FD OS. I still believe to this day that ZAGG is one of those rare situations where both business growth and share structure are in perfect harmony, thus creating a perfect storm that leads to sustained stock price accelleration. 

On the other side of the spectrum, a problem occurs when a company has too few OS as there is little liquidity in the market place for the stock. I could list 50 different companies with 1-4 million OS and the problem is that they don’t trade enough volume for any serious investor to get involved. As a retail investor, I’m looking for stocks that will go to the next level and that means attracting institutional investment.  Someone needs to buy my shares off me at a higher price ;) A small fund isn’t going to buy a stock that trades 1,000 – 10,000 shares a day. How will an institution ever be able to pick up a meaningful position (or get out of a position) without moving the stock price quite significantly, so most funds will just pass. This is a problem and one to stay away from. For me the sweet spot for FD OS is around 20-30 million.  
 

Insider ownership is an important qualitative component in any stock. I normally like to see insiders owning between 20-60% of the FD OS. Too little insider ownership might show not enough alignment with shareholders meaning management doesn’t have enough skin in the game to do what’s right for shareholders. I can sometimes overlook lesser insider ownership under certain circumstances, such as when a new management team takes over a company, etc. In my experience it is also bad to see insiders owning too much of the company such as when the CEO owns 70%+ of the FD OS. I’ve found that in these situations the CEO acts too much as a dictator and not as a shareholder advocate.
 

I’m going to stop writing now as I hate reading long blog posts and this for some reason is turning into one of those. I wanted to make a few more points but am tuckered out and quite honestly I don’t want to disclose all my secrets ;) There is no greater motivator and educator than losing money. I learned from making investments and losing money just like many others, and it is amazing how many investors continue to overlook the importance of a good share structure. Through the years my batting average continues to increase and I hope yours will too. We are only in this for the money. 

 

Disclosure: Long EGMI and Long ZAGG. No affiliation with EGMI. I am an advisor to ZAGG. http://iancassel.com/disclaimer/