You Can't Cut Corners in the Market

The market has done some strange things in the past three years...

When COVID-19 turned our world upside down in March 2020, investors feared a severe fall in the market. To many folks' surprise, that dip only lasted a few months.

Companies figured out they could operate well in the pandemic era. Plus, stimulus money helped keep things moving during the very worst months.

That mini-bear market was only the first oddity, though. The resulting economic rebound – coupled with an inflow of stimulus checks and people stuck inside their homes – led to a powerful trend that no one saw coming...

The number of retail investors exploded.

Rookie traders accounted for between 10% and 15% of volume between 2011 and 2019. In 2020, that number hit 20%.

Many of these new investors lacked any market experience. They didn't know how to do proper financial research. Instead, they piled into recommendations from social media site Reddit and other questionable sources.

That's what led to the now-infamous GameStop (GME) short-squeeze. In the span of one month, the video-game retailer's stock skyrocketed from $4 per share to $81 per share... and back down to $16 per share.

Some of these folks got lucky. They bought in at the bottom and cashed out at the top, making a fortune in the process.

However, for every new investor who managed to "get rich quick," another lost out big time.

As we begin 2023, it's important to look back at the events that got us here.

So today, I want to explain where a lot of amateur investors went wrong... and how you can avoid their mistakes in your own investing this year.

The 'meme stock' mania was a wake-up call for a lot of people...

It showed the masses that investing can be a great source of income. It also highlighted the importance of doing your due diligence.

Said another way, cutting corners doesn't work on Wall Street.

This doesn't only apply to new retail investors. Plenty of companies cut corners in 2020, too.

One of the easiest ways to see this is by looking at what's called special purpose acquisition companies ("SPACs").

SPACs don't have any commercial operations. Rather, they raise money by going public through an initial public offering ("IPO")... with the sole intention of acquiring an existing company.

The normal IPO process can take over a year to complete. Going public through a SPAC only takes a few months.

So SPACs were popular during the pandemic because they offered a quick "back door" route for companies that wanted to go public.

It's important to keep in mind that SPACs have been around for years... and some of them are perfectly legitimate.

However, as this investment vehicle gained huge popularity in recent years, a lot of companies saw a way to take advantage.

In 2019, 59 companies went public via SPAC. In 2020, that number was up to 247. And by 2021, that number had hit a staggering 613 companies. That's an increase of almost 940%.

This presented a serious threat to unknowing investors...

You see, the IPO process is long for a reason. There's a lot of regulatory work that goes into making sure a private company has sound financials and operations. This is a critical step before that business can be made available in the public markets.

A lot of companies were able to bypass this process by going public via SPAC. Unsuspecting investors weren't sure what they were signing up for when they bought shares.

An increase in rookie investors and cheap leverage created the perfect environment. A lot of SPACs took advantage of it. And people lost an unfortunate amount of wealth in the process.

According to CNBC, the average company that went public via SPAC had lost more than 50% of its value from the start of 2022 through June. Since then, most post-SPAC companies have continued to fall.

To add insult to injury, it seems like many of these companies have bigger issues with their financials.

The Financial Times reported some alarming statistics last month... Almost half of the companies that went public via SPAC since 2020 have material accounting deficiencies.

These companies had something wrong with their internal controls, management, or other issues that accountants should have caught. Investors should have known about those problems.

If a company cuts corners to go public, it could be cutting corners in other places...

That's why investors need to be careful where they're putting their money. It's not enough to look at the fundamentals – although that's an important first step. To get the full picture of a company's operations you have to dig deeper...

Red flags like management misconduct, poor auditors, bad accounting, and shady management history can warn you away from a business.

These are the sorts of signals we look for in our Do Not Buy List, which we publish each quarter for Microcap Confidential subscribers.

(We published our latest edition of the Do Not Buy List last Friday. To learn how to gain access, click here.)

While we have a team devoted to doing this work, there's still plenty you can do as an individual investor.

Anyone can look up who audits a company. And more important, you can see how that auditor is graded by the Public Company Accounting Oversight Board – the government's "auditor of auditors."

If a company's auditor has a bad reputation... that's a big, fat red flag.

A company's headquarters can also tell you a lot about the business. We've looked up headquarters in the past, only to find out the address points to a trailer in an executive's backyard.

And if management members have a history of fraud, it's probably a good idea to stay away. Don't assume they'll have a change of heart this time around.

These factors are relatively quick and easy to check... And they can save you a lot of grief in the long run.

So as we head into 2023, take it upon yourself to know where you're putting your money. Do some simple forensics work before investing in anything at all.

It might save you from the next great investment implosion that nobody saw coming.

Regards,

Joel Litman
January 3, 2023