Don't be a sucker when it comes to stocks

Updated March 22, 2008. Edits explained at the end of the post. - ST

I was reading a news item about the resignation of Mathstar's chief financial officer. I was surprised to see a publicly traded semiconductor company I'd never heard of, so I checked it out.

Turns out that Mathstar is like a number of companies I've come across over the years: they come in under the radar screen and, as such, investors think they've found something special.

Sure, these companies are special, but not in a good way.

Mathstar markets itself as a development-stage fabless semiconductor company. Its products are called field-programmable object arrays, or FPOAs, and are targeted at high-performance, data-intensive applications like defense, security, medical imaging, and video.

Sounds good, right?

Then why is the stock trading at about half a buck with a whopping market cap of $23 million? Good question.

According to my research, the company's market cap may be $23 million too much. In 2007, the company had record revenue of--get this--$558,000. You read it right. But the annual net loss was a hefty $20 million. The company has burned through more than $100 million of investment capital, to date.

Strangely, the company wasn't trying to hide anything when it went public. Its S-1 prospectus said, "We do not know whether or when we will be able to generate significant product revenue or become profitable."

Mathstar indeed went public in October 2005, raising $12 million by selling 2 million shares at $6 a pop. The offering's underwriter was Feltl & Co., a securities broker based in Minnesota.

Today, Mathstar's share price is down more than 90 percent since its IPO. The institutional investors that bought into the public offering aren't just suckers, they're incompetent suckers. I say that because they're not playing with their own money; their funds invest other people's money. Sad but true.

Don't get me wrong: pre-revenue IPOs still happen, especially in the biotech industry. In that instance, investors know they're taking a big risk for big upside rewards. In the case of Mathstar, however, investors got the risk without the big potential upside.

The company essentially used the public markets in place of what should have been a round or two of venture funding. It makes you wonder why they didn't go the private route. Maybe they tried and couldn't. Something to think about.

I thought this kind of thing went out with the Internet bubble, but I guess I was wrong. There are apparently still plenty of suckers left out there.

This is just an example of a phenomenon we see from time to time: a company manages to go public when there's no logical reason for institutional investors to buy into it. These companies typically raise a few million bucks and then, in agonizing slow-motion, fizzle out of existence.

The big question, of course, is what can investors do to avoid disasters like these? Well, three things come to mind.

First, if it sounds too good to be true, it probably is.

Second, if it's coming in under the radar screen, there's probably a good reason for that.

Third, successful investors don't take huge risks unless there's a very good reason to do so, and a sales pitch by a Midwestern investment bank about a company with no revenue certainly doesn't qualify as a good reason.

Bottom line:
There are thousands of companies with cool technology, but only a small percentage of them will end up providing good returns to shareholders. If you don't know how to pick them, odds are you'll end up losing. After all, an IPO only takes an underwriter and enough suckers to buy the stock. Don't be one of them.

Modification: Deleted paragraph 15. It listed a number of companies that, in my opinion, also fit the bill. However, that ruffled some feathers, specifically because my metrics were subjective. As we know from investing 101, past performance is not a guarantee of future results. As such, stock performance to date certainly does not tell the entire story of a company's potential. Consistent operating growth and a solid balance sheet should eventually be reflected in share price, one would hope.

Also, much of what I write is commentary and I've been wrong before. If you ask my wife, she'd probably say I'm occasionally right.