Stocks in the Spotlight's "Never Buy"

One of the first signs of a bad investment is when we discover the management team allowed the shares outstanding to increase beyond a manageable amount. This happens because so many companies become public without enough of the funds needed for the company to do business. They find an old public company doing nothing, buy-out the existing insiders, do a big reverse to say good bye to the previous shareholders and start trading.

Since these new companies have no money the management team will do a private placement to raise money. This part is fine, as long as the price paid is near the high end of the old range and they don't sell too many shares, but most companies in this situation go ahead and raise money without any consideration for the dilution at low prices.

Now the company has some bucks and should now be able to move forward on the business plan. What happens next is most run out of money, because they didn't raise enough, because of the low price of the Private Placement and now they will need to do another private placement and more dilution.

What happens now is the stock falls to a new low because of the constant dilution at lower than market prices The problem now is the stock is probably down too far, because the company has done little, and they have to sell many more shares then before in order to raise the same amount of dollars.

This action becomes a habit and before we know it the company is trading at a few pennies with more than 100 million shares outstanding, because there were so many private placements all low prices.

I am very serious about this and it is the downfall for many start-up public companies. Like all businesses, marketing does not happen, it is planned, but it seems like the average new public company has either never learned this important lesson, or just forget about it.

I have seen this happen so many times, and for so many years now, that even I am getting a better handle on it. It truly is a hard lesson to teach and learn, simply because valuable (limited) dollars seem to find other things that at the time seem more important.

Here is the catch. Other things may seem more important, but the common stock in a public company is the very most important asset it has, and if a management team can learn this the road to success will be much easier to travel.

Float! Float is the total number of shares trading. It does not include insider stock. Remember this because it is the main item in how a stock trades. The stock market was designed as a "supply & demand" business. The fewer the shares, the more the company is worth per share, the more it cost to become a shareholder, or another way of saying it is , the higher the price on the shares. The opposite of this is, of course, the more the shares the lower the price of the stock.

They are called "Market Maker's" (another word would be Wholesaler's) and it is there job to make a market in the stock by offering a bid price for the sellers and an offer price for the buyers. If there are more buyers in the stock the makers will raise the price they are willing to "sell to us". If there are more sellers they will lower the price they are willing to "buy from us".

What makes the prices the Market Maker's set has to do "entirely" with "supply & demand". A well known company, such as Apple Computer, or Microsoft, has so many shareholders the supply usually equals the demand, give or take some movement in the stock over time and this makes the market maker's job much easier .

The market maker makes money on buying shares at a lower price than they sold (shorted) them to us. A quote of 0.50 X 0.53 would mean if the makers sold 1000 shares at 0.53 ($530.00) and bought 1000 shares at 0.50 ($500.00) they made 0.03 ($30.00) profit. This trade may only take a few seconds and the maker is now "covered".

Covered is a key word and it is the whole ball of wax. When the maker sells us stock, s/he does not have it, therefore, they give it to us anyway in hopes of buying it back lower. This is called "shorting", because they sold stock they didn't have. They must buy it back, someday, since they already sold it. Once they do buy the stock back they have "covered" the short position.

Now comes the problem. If a stock is trading at a dollar and the market maker shorts 100,000 shares, s/he is at risk for 100,000 dollars. Odds are the maker won't short that much so as to limit the risk. If the stock moved up to $1.10 on the bid the maker stands a chance to lose $10,000 because it would cost 1.10 per share to cover the 100,000 short.

Now look at what happens if the stock is trading at 0.02 X 0.03. If the maker sells us 100,000 shares at 0.03, s/he is at risk for only $3,000. If s/he shorts a million shares the risk is only $30,000 and if they buy it back at 0.02 they make a cool 10 grand. Not bad!

The lesson to be learned. If there are so many shares trading, and the price of the stock is under a dime, the market makers do not worry about shorting a million shares, or more. Since the demand is supplied with stock that does not exist (short) the maker's will keep shorting until the demand dies off, which in turn creates the selling. If there are more than 100 million shares out there the market makers will will always find sellers.

Since the demand is covered with a can of air, once the demand falls off the stock drops fast and the market makers make a bunch of money. Keep in mind, There may be as many as 10 or more makers, meaning the ability to short ten million shares is almost the norm, guaranteeing the stock price will stay about the same until the demand dries up.

It is simply the supply of stock that is unlimited when there are more than 100 million shares outstanding in a low priced stock. The demand is usually limited when the supply is not, and it has little to do with what the company does.

I hope this is not too confusing. The main point is avoid stocks with too much "possible" supply at too low of a price where Market Makers are not afraid to short millions of shares.

JR Budke
Stocks in the Spotlight
209.204.2902
spotlite@thespotlite.net
www.thespotlite.net

The Stocks in the Spotlight is not an Investor Relations or Public Relations firm, but a stock market related web site with opinions and recommendations. It also has to do with equity strategy, with a desire to assist in the various methods of increasing the value in a public company. If you need assistance in equity strategy, or consulting, please contact us at the above telephone or E-mail address.