Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? - Small vs. Young

by Geoff Gannon


Sivaram – of Can Turtles Fly? – asked a great question about my post on microcap stocks:

How about poor corporate governance? Based on your experience, would you say it's hard to price the risk of poor corporate governance?

Yes.

It's very hard to price the risk of poor corporate governance. But in my experience: people generalize way too much about big caps having good corporate governance and microcaps having bad corporate governance. Big caps get more attention from outsiders. But big caps can still have bad corporate governance. The issue is that fewer people are paying attention and looking out for you in microcaps. You aren't going to have analysts, reporters, fund managers, and activists - until things get real ugly - looking out for you and saying bad things about management in microcaps. You will have that in big caps that do wrong by investors.

One huge warning: There are microcap frauds.

I would say - and this is just my own experience talking – microcap frauds tend to be in more speculative and young companies rather than purely small companies. A lot of small companies are also young so people get the two confused. Old microcaps are often like old big caps and young microcaps are often like young big caps.

Another thing to look for in terms of fraud is a company that wants to stay public regardless of the business it’s in. Some microcaps will change their business completely more than once without ever going private. Does that worry me? Sure. There may be exceptions. But if a company wants to stay public more than it wants to stay in the same line of business that’s a huge warning sign that something is very wrong with management.

At the other extreme: a microcap that is an old, family controlled company with tons of retained earnings in some mundane business is often just that. If it's hoarding cash, it's usually doing it for the same reasons a big cap company hoards cash. Management has few options in the existing business and doesn't know much about putting money to work elsewhere. They aren’t doing right by shareholders. Paying the cash out would be better. But they probably aren’t criminals either. They’re probably just humans running a no-growth business that throws off more cash than they can use.

I would read the SEC reports carefully. Some people come to different conclusions. So for me all the George Risk (RSKIA) related party transactions - and there are a ton of them - aren't nefarious, because if you look at the actual dollar amounts they aren't generous. The family doesn't pay themselves as much as it could get away with, it doesn't pay the board at all, and the other transactions aren't egregious.

Then look at a bigger stock I'm in: Barnes & Noble (BKS). The Riggio related party transactions are egregious. Len's brother, Stephen, stayed on as Vice Chairman after they got a new CEO to replace him. The interest rate Len got on the college booksellers deal is high. There are lots of examples.

So it depends.

Corporate governance is a huge issue. But investors tend to think being naive is a worse crime than passing up an opportunity because you assume the worst in people. There is good and bad corporate governance at all market cap levels. It depends on the history of the culture, the way the company is controlled, and the ethics of the people running the place. Not just size.

Talk to Geoff about Microcap Stocks