Not for the faint of heart

Most financial advice cautions against us putting money into high-risk investments. If you are looking for the jackpot, you're best advised to buy a lotto ticket.

But what if you've already got a well-diversified portfolio and you're looking to take on a little more risk in exchange for the possibility of a big return? That may sound like a financial unicorn or the makings of a Ponzi-type scam, but these types of investments do exist. Yet they often cannot be found on the well-trodden paths to financial health.

In particular, two often-overlooked areas of investment -- small-cap stock and exempt market investing -- can provide the prospect of higher than normal returns, albeit with additional risk.

While investing a large portion of your savings into these less-travelled spaces is definitely not advised, these types of investments do bear some consideration for those with already well-diversified portfolios, looking to spice things up a little. In this respect, the legitimate players in these investment arenas will -- and should -- caution investors against getting in too deep.

"We tend to take a let's-get-our-feet-wet approach first," says Barré Hall, vice-president with Winnipeg-based Hatch Alternative Investments. "We encourage people to go toward the lower end of the investment spectrum rather than the higher end."

Even very aggressive investors should have no more than 20 per cent of their investable assets in either the small-cap stock or the alternative market, which can include hedge funds, private debentures, limited partnership real estate deals and just about any other type of investment that is not publicly traded with a prospectus.

In some ways, the two areas share commonalities. Both tend to be riskier-than-average investments, but investors are often compensated with higher -- sometimes exponential -- returns.

Small-cap stocks -- companies with a market capitalization of less than $1 billion -- can offer this potential windfall more than any other class of publicly traded investment.

Often traded on the TSX Venture Exchange, the majority are speculative investments -- particularly exploration companies looking for deposits of precious metals, says Ryan Irvine, a senior analyst with Vancouver-based Keystock.com.

"If you're talking about buying a company with a moose pasture somewhere in Saskatchewan, which is, to put it bluntly, what many of the exploration companies on the venture exchange are, you really are talking about a hope and a dream," says Irvine, president of the monthly, fee-based service that provides independently researched buy/sell reports on the small-cap sectors in Canada and part of the United States.

Doing your homework is essential to finding small companies that offer value and have the potential to grow.

Using the GARP model -- growth at a reasonable price -- successful small-cap investors try to find undervalued, profitable companies before the rest of the investment world discovers them, Irvine says.

"We are able to find, through painstaking research, companies that are trading at 10 cents to $5 with good, solid revenues, cash flow and earnings that trade at reasonable valuation that give you the chance to make that long-term or near-term gain in that sector without taking on the level of risk that many people believe you have to take within the small cap," he says.

But even the attractive small-cap companies are extremely vulnerable to price volatility because they are often traded in smaller volumes, and many are in their infancy, highly dependent on a bull market when capital flows freely.

For that reason, look for companies with revenue, money in the bank and no debt (they do exist).

This can be no easy task, however, since understanding balance sheets and other financial data takes knowledge, meaning guidance may be required. And that, too, can be tricky because it can be hard to measure the value of the advice.

In many cases, the typical adviser isn't cut out to offer information on this area of the market because it is under less scrutiny than other stocks.

"By definition, if you have one to zero analysts following your stock, there is a possibility of finding an inefficiently priced stock as opposed to a TD Bank, which has thousands of analysts following them at any given time," Irvine says.

The lack of coverage can be both a blessing and a curse. What if the analyst is wrong? The potential is there to lose almost all your money. Then again, if the lone analyst is right, you get in on a stock before it becomes a hot commodity.

The alternative investment world offers that similar sort of opportunity -- a little-known investment with higher returns in exchange for higher risk.

These are exempt market investments and, as such, are not required to file a prospectus with securities regulators. They are not publicly traded so investors are somewhat limited in what they can find out about them, says Sheldon Stier, president of Hatch.

Investors are reliant on the wisdom of their advisers or their own financial sophistication to determine if the investment is sound.

And similar to successful small-cap investing, this investment space finds opportunities that have been overlooked by the broader investment community.

"We try to take what the rest of the world might perceive as lemons and take that opportunity to raise money and do something that you would never be able to do with the public market, because it takes too long, legally, to put the documents together and go out and raise money on a public exchange," he says.

Unlike the small-cap arena, which often falls and rises with the broader market, the alternative investments do not mirror markets as closely, meaning it can help mitigate declines in your overall portfolio in a bear market.

But the alternative investment space has risks. As previously mentioned, transparency can be problematic. Information about small-cap companies is filed with SEDAR, the national database for publicly offered companies. This is not the case with exempt-market investments.

In addition, they are often illiquid. You can't easily sell them for cash, because they are not traded on an exchange.

"Consequently, an investor will typically target a higher rate of return to compensate himself or herself for the lack of liquidity -- in other words the inability to resell or exit the investment immediately," says Hall. Hatch, for instance, offers a bond-like debenture offering with 12 per cent interest over five years.

Of course, the question you might want to ask is why would a business be seeking money at such a high rate in such a low-interest climate?

Finding that answer means doing research and leaning on trusted advisers for guidance. And at some point, you'll have to make a judgment call to determine the legitimacy of those offering the deal.

"Be very wary. We've seen a lot of cowboys come into town," Stier says.

The promise of big money may be dazzling, but only sober, thorough evaluation will separate the money-makers from the speculative and often money-losing deals.

"It's really irrelevant if this thing is public or private," Stier says. "The question is whether it's a good investment opportunity."

Providing investors are willing to put in hours of research, or pay for independent, trusted advice, both small-cap and alternative investing can be a valued portion of a portfolio. Just remember: These investments may not take a short or smooth rise to prosperity.

As Irvine aptly puts it, "It's not for the faint of heart."

giganticsmile@gmail.com

About the exempt market

More often than not, alternative investments are the realm of the well-informed, higher net-worth investor. Securities regulations are set up in such a way that investors must meet at least one of the following financial criteria:

1. Anyone in Manitoba can invest up to $10,000 in an alternative investment, providing the deal comes with an offering memorandum (OM) and a risk acknowledgment form, which must be signed by the investor.

2. If investors want to invest more than that amount, they must have a certain level of wealth to qualify as an eligible investor -- as long as there is an OM. To qualify, an investor must make, for the past two years, $75,000 in annual income or $125,000 combined income with a spouse for the past two years. Or, an eligible investor can also have a net worth of $400,000, combined with assets of a spouse and including property.

3. Investors with even more financial wherewithal can invest any amount in a deal, even without an OE. These are called accredited investors. An accredited investor must make at least $200,000 a year (or $300,000 combined with a spouse) for the past two years; or an accredited investor (combined with a spouse) must have $1 million in investable securities or cash or $5 million in net worth, including property. "Basically, if you're accredited, you can invest in a deal written on the back of a cocktail napkin," says Sheldon Stier, president of Hatch Alternative Investments.

4. But you don't necessarily have to be accredited to be involved in a deal written on a cocktail napkin. You also would qualify if you were willing to invest a minimum of $150,000 in a proposed deal. At that amount, regulators expect it will preclude most investors who do not have scads of money on hand to invest, Stier says.

Creating your own mini-portfolio of small caps

Ryan Irvine, senior analyst with Keystock.com, advises against investing in just one small-cap company. It's better to invest in five to 10 companies with strong revenue, earnings and cash flow, and no debt. Furthermore, do not invest in companies in only one or two sectors, such as mining or oil and gas services. Diversify by picking one or two good companies each in a number of sectors. "You go out and you create your own little mutual fund in this segment," he says. "If your overall portfolio is $50,000, you are maybe going to buy $1,000 of stock in each and then you have five companies."

How much to invest?

Depending on your propensity for risk, a well-advised or experienced investor could allocate between 10 and 20 per cent of their portfolio to either small cap or alternative investing. They tend to involve more risk than other investments, but good homework and advice can mitigate risk. Still, even the best-laid plans can be blown apart by unforeseen circumstances. Ask yourself: How much can you afford to lose and still rest easy at night?

Just what constitutes exponential capital gains on small-cap stock?

WaterFurnace Renewable Energy, Inc, formerly WFI Industries Ltd, traded at $1.50 in 2001. Today, the geothermal heating and cooling manufacturer trades at around $25 a share.

Republished from the Winnipeg Free Press print edition June 14, 2009 C7