The downside of investing in emerging companies

One of the theories emerging about the bailout is that the Obama administration is trying to reshape American industrial policy towards an economy that makes stuff again, as opposed to merely trading securities, and to make it greener and more environmental sustainable. The real litmus test will be market reaction to the launch of  GM’s electric car, the Volt,  which can either save GM or be the final nail in its coffin.

With the market stabilizing somewhat, many companies which have business models built on environmentally friendly technologies are bubbling up again looking for investors, having had the capital markets abruptly shut on them in September 2008. Thus, we are seeing the return of penny stock companies  or companies raising money by private placement looking for investors to develop clean coal technologies, bring to market lithium-ion batteries or refine heavy oil etc. etc.

Should you take a chance on these types emerging companies? Everyone wants to invest in the next Research in Motion but there are a couple of things to remember.

1. Invest in what you understand. One of the fundamental rules of investing is only buy what you understand. If you last took science in grade 10, how would you know if the penny stock that was in the agricultural fuel business actually had a viable technology or a distribution channel behind it? It is hard to call someone on techo gobbledygook if you can’t spot it.
2. Investing in growth stocks are not a great way to create wealth. Seymour Schulich ran a Morningstar screen that showed 2,214 publicly traded companies with 20% sales growth declined to 669 one year later then 349 then 179 then 87 (or 3.9% of the original class) in year 5. In other words, it is difficult for growth companies to continue growing.  If you invest in the downside of their growth curve, you may have over-paid for your investment.
3. First-mover advantage can be eroded quickly depending on context. First mover advantage is the business theory that the first to the market gain an advantage over its competitors. It has both its supporters and detractors. In highly regulated industries with large capital costs, it can be a huge advantage to be first to market since you can set the rules of your industry and consume finite resources (see how traditional teleco’s moved into the cellular space). Where the industry has a low barrier to entry, investing in a first to market business may not be the most prudent move since subsequent competitors can reverse engineer the product or out-business model your business model. This is one reason why tech start-ups die a terrible death or why Amazon.com beat books.com even though it started 4 years later. The key for a potential investor is to do your independent homework and understand the industry well.
4. Invest only what you can afford to lose. Many emerging companies are high risk, high reward plays. Be prepared to lose it all.
5. Exit strategies can be problematic. Penny stocks listed on a OTCBB or a private placement investments can be highly illiquid or can have trading prohibitions on them for a period of time. It may be difficult to exit this stock even if the share price is up given a lack of trading volume. Combining 4 and 5 together, only invest your silly money which you do not need access to in the short term.

There is a certain excitment of being in on the ground level of an emerging company but just be aware of the risk as well as the potential rewards. Good luck.