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Getting in on Early-Stage Companies

Question from a Reader: (links mine, in case you have not read the articles I think he's referring to)

Hi, I'm a very small time investor and I have a strong longterm belief in the alt energy sector. I have one gripe with the sector, though - the fact that it's hard to get in all the way at the bottom, ie: from the birth of companies. I have a feeling that much more growth will happen at that level, and investing in something like ICLN gets me into mature companies that have much less growth potential.
 
Would you be able to write about what a small time investor like me can do to get a better coverage of the market (especially the bottom end of the market) with limited funds. Ex: VC's if there are any publicly traded, or any other instruments I can't think of.
 
Really appreciate it. Oh, and congratulations on an awesome website! It's one of my favorites, and my one stop shop for alt energy news!
 
Thanks
 
S

TK:

This problem is not unique to the energy sector.  In general, early stage companies are very risky, and sometimes dodgy.  Unlike more mature, listed companies, it's difficult to find good analysis, meaning that you have to do most of your own research.  If you're investing just a couple thousand dollars in a company, the work necessary can make it very difficult to earn enough on the ones that do well (and gains can be as spectacular as the losses) to pay for your time.

However, if you have time on your hands, the place to look for spectacular potential gainers is in penny stocks.  There are especially large gains to be had when a company gets a listing on an exchange, which means that they are now subject to a lot more oversight, and hence many other investors are willing to invest.  One of my most spectacular gainers last year was US Geothermal (HTM), which I bought at $.85 before it got a listing, and it's now trading over $2 (it has been higher.)  Other penny stock investors (I do very little investing in these companies) will doubtless regale you with stories of much more spectacular gains... but they seldom tell you about the losers.  Part of the reason I do so little pink sheet investing is I find that for every US Geothermal, I end up with one or two dogs, so, on average, my pink sheet returns are no better than my returns on listed companies.

For those willing to brave the odds, however, I put together some tips last year about how to start your research on penny stocks by listing some common warning signs.  Also, because these companies are very volatile, you are likely to be able to greatly increase your returns by knowing when to sell.

DISCLOSURE: Tom Konrad owns HTM.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.



was posted on AltEnergyStocks.com.


       

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Comments

Tom,
Your reader asks one of the toughest questions in finance.
Put another way, how can a portfolio investor even hope to capture the growth of the economy (plus inflation), much less exceed it, if they are excluded from the fastest growing fraction of the aggregate, non-public companies.
.
Another related question is:
How long can earnings grow faster than the economy?
Greenspan was gung-ho on productivity gains but a lot of that is a chimera of hedonics. And Ibbotson-Sinquefield was right in 1976 but possibly for the wrong reason. The P/E multiple expansion from The Aug. '82 bottom to the Mar. 2000 top was 7 to 44 (trailing, reported) on the S&P 500. Pretty much proven to be unsustainable.
.
These hard facts explain the rush to Private Equity and Venture Capital but the flood of money will reduce returns going forward.
So what's the answer?
1) You must have exposure to companies growing faster than GDP + inflation.
2) You have to take on risk and then try to mitigate in every way you can. One easy example, deal ONLY with people you trust. It works for Warren
3) Pay attention.
4) Ask yourself why both Berkshire Hathaway and Merrill Lynch bought 6-6 1/2% annuities to wall off their Defined Benefit liabilities. (I know part of it was ERISA compliance and costs but still).
All in all a really smart question.

Thanks for the thoughtful comment, Climateer. Alwas nice when readers can answer each other's questions.

Earning excess returns is always very difficult, and there's nothing easy about it. If your portfolio is small, you may end up richer by accepting indexed returns and putting your efforts into earning money the old fashioned way. The one downside of this is that, by the time you have enough money to make active investing worth your time, you have not acquired the skills... so if you do want to take an active approach as a small investor, work on improving your skills... in the long term, those will be worth more than an extra percentage point on a few thousand dollars.

Tom,

Is share dilution a red flag for early stage companies? A company with three billion shares at one cent apiece and thirty million shares at a $1.00 obviously have equivalent market cap, but the former case would give me pause. My concern is management at the first company tends to pay anyone and everyone in stock at the expense of current shareholders. Would appreciate your insight!

Thanks,
Ryan

Ryan:
The biggest worry about share dilution is with convertible debt which converts at some fraction of the market share price... if new shares are issued at only a slight discount to the current market price, it's not nearly as big a deal... the problem with the convertible debt is that it tends to aggravate a downward price spiral.

Some level of new share issuance is expected in early stage unprofitable companies. So long as each successive round of shares is issued at a higher price than the last, there is little reason to worry.

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