By Haddon Libby
Has anyone ever approached you to invest in ‘the next hot thing’ or a ‘can’t miss opportunity’? For every legitimate start-up or small company, many fail despite the best of intents with many more formed and failing with fraudulent intent.
How do you spot the potential opportunities over the failures or frauds?
Sophisticated investors typically start by looking at the quality of the management team. Do they have the experiences to potentially achieve success? What are their resumes? Are they trustworthy? Is their financial strategy en route to future success reasonable?
As an example, let’s look at companies that have retired four star general Wesley Clark on their Board of Directors. General Clark served in the U.S. Army for thirty-eight years and rose to the position of NATO’s Supreme Commander for Europe. While in that role, Clarke helped protect 1.5 million Albanians from ethnic cleansing during the Kosovo War. He also graduated at the top of his class from the West Point Military Academy and has undergraduate and graduate degrees from Oxford University in philosophy, politics and economics. This Rhodes Scholar briefly toyed with the idea of running for President in 2004 and sits on the Advisory Board to the General Accountability Office (GAO) and serves as a Distinguished Senior Advisor for the Center for Strategic and International Studies and serves on the board of the American Council on Renewable Energy.
Impressive resume!
A deeper look shows that while General Clark has served on the Boards of successful companies like CVR Energy and online poker company, Amaya, he has also lent his name to more penny stock companies than all but four of the nearly 31,000 board members that Bloomberg tracks. Most penny stocks where Clark sat on the Boards are now worth less than before he joined with many going bankrupt.
Additionally, Clark rose to be Chairman of investment banking firm Rodman & Renshaw – a firm that closed its securities business after it was found that many of the Chinese firms that they took brought to the public markets were fraudulent.
Given that a decorated four-star general can be repeatedly involved in highly suspect companies, how can you protect yourself from these bad investments?
First, be suspect of companies trading on the Pink Sheets. If a stock trades with a .PNK after their symbol, it is a Pink Sheet Stock. Most Pink Sheet companies do not report audited financials and have questionable financials. While there are legitimate companies listed on the Pink Sheets, this market segment is fraught with fraud and risk.
If the company was formed through a reverse merger, be leery. Reverse mergers are where one company is acquired by another so that the acquiring company can raise money and trade their stock more quickly. While many legitimate companies use this method, this way of a stock “going public” has more than its share of dishonest people.
Another way to spot suspicious companies is to review their financials. Audited statements by well known, respected accounting firms are important. That said, Enron used a top shelf accountant and perpetrated one of the largest frauds in history. Generally speaking though, if all you have is a hyped unaudited financial statement that discusses the future while posting large losses in the equity section of their financials, be very leery.
Other warning signs include lots of press releases on new strategic alliances or products with limited to no financial results or “buy” recommendations from unknown analysts and firms. Finally, if you are seeing surges in the number of shares trading on a small stock, there is a very real chance that the stock price is being manipulated.
If you feel the need to invest in these small stocks, consider your investment to be the equivalent to an investment in a slot machine in a casino.
While you may win big, the odds are very much against you.
Haddon Libby is Managing Director of Winslow Drake, an investment management practice, and can be reached at hlibby@winslowdrake.com
