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Why you should avoid microcaps, a hot lumber stock, and all that you need to know about pot stocks

Marijuana plants are seen in a room at a grow facility in Denver, Colo., on Dec. 9, 2015.

Matthew Staver/Bloomberg

In the late 1990s I made a lot of money on microcap technology stocks but then I gave it all back. Part of it was that I was young and stupid but I don't buy smaller cap and penny stocks anymore.

There are people, besides commission-based brokers, who do make money from penny stocks. This requires very specific knowledge of the company and extremely close focus on every move in the stock price.

It is rare that microcap financial results and valuations are very useful. They are in most cases basically a call option on an eventual growth story. There is also a distinct survivorship bias involved when talking about the category as whole. Small cap traders will give you chapter and verse on the one stock that went from  $0.12 to $1.75 but many microcap stocks just disappear after bankruptcy, leaving no evidence of failed speculation.

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As Alexandra Scaggs from the Financial Times' Alphaville blog underscored in a Tuesday report, there has always been some desperate 'get rich quick' seediness where penny stocks are concerned. This is particularly prevalent when tiny companies are about to attempt to raise funds in the market.

Ms. Scaggs, focusing on U.S. small-cap stocks, detailed a U.S. Securities and Exchange Commission finding that stock promoters were secretly paid to write glowing stock reviews for publications like Forbes magazine and TheStreet.com.

The vast majority of investors should avoid individual small and microcap stocks. The deck is stacked against them -- the financial reporting is unhelpful, the available information could be ethically dubious, and few investors have the knowledge or time required.

Like playing the lottery, it's fun to dream of hitting it big in microcaps, but investors' odds of success are not a ton better than a casino.

-- Scott Barlow

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Stocks to ponder
 

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Norbord Inc. Higher commodity prices are boosting share prices for the forest products group. Late last week, the price of lumber jumped 2.6 per cent. Norbord is from this leading sub-sector and its share price has rallied 20 per cent so far in 2017 with further upside anticipated by analysts.  Housing strength and this spring's selling season may continue to lift this sector, writes Jennifer Dowty. The average one-year target price is $42.46, implying approximately 5 per cent upside potential in the share price over the next 12 months.


Restaurant Brands International Inc.
The company recently bought Popeyes Louisiana Kitchen, after its 2014 takeover of Tim Hortons. But Tim's franchisees are voicing their concerns over what they say is the destruction of the brand. Is QSR a buy? Critical to QSR's operations is the leadership of the gents from 3G Capital, a Brazilian group that prides itself on efficiency. At both Tim's and Burger King there is no question that this dramatically reduced expenses and improved the bottom line. But one has to wonder if it is a case of trading short-term gain for long-term pain, writes The Contra Guys. Some pretty smart guys own the stock, including Bill Ackman and Warren Buffett. But the Contra Guys suggest the stock could be in for "some major indigestion."


Canada Goose Holdings Inc.
The stock received strong praise and a healthy dose of high expectations from the Street on Monday as a bevy of research firms came off restrictions from covering the stock after being involved as underwriters, writes David Leeder. Eight equity analysts initiated coverage with a "buy" or equivalent rating. Four gave the Toronto-based retailer a rating of "neutral" or equivalent, according to Bloomberg data. The 12-month average price target is now $24.77, and the stock was trading near $22.50 on Tuesday.


Yangarra Resources Ltd.
This company is a top performing stock in the energy sector, rising over 48 per cent so far this year, writes Jennifer Dowty. All seven analysts who cover the company have buy recommendations on the stock, and the consensus target price suggests 37-per-cent upside potential for the share price over the next year. However, on a technical basis, given the recent sharp rally, in the near-term, the positive share price momentum may pause, with the stock price potentially pulling back to a level between $2.50 and $2.75.



The Rundown


How to stay informed about markets every morning

Globe Investor this week launched a new daily blog that we think readers are going to like. Five things investors need to know highlights the latest developments in markets starting before the opening bell and continuing throughout the morning. We highlight what's going on in equity markets, how commodities, currencies and bonds are faring, what's happening with the loonie and greenback, the latest economic news and the stocks that are going to be on the move. This mobile-friendly daily file also provides continuously updated charting and price quotes. Watch for it by 730 a.m. (ET) each day on our desktop and mobile home pages.

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A Canadian investor's guide to marijuana

By next year, Canada's legal marijuana industry could transform from a multimillion-dollar market serving thousands to a multibillion-dollar market serving millions. The Liberal government is expected to introduce legislation as early as next week to legalize marijuana for recreational use, making good on a campaign promise to dismantle the illegal market. Legalization, which reports have said could come into effect by July 1, 2018, will anoint Canada as a global leader in regulated cannabis consumption and thrust the country's production industry into high gear. See this in-depth guide to what investors should know about this burgeoning industry.


Marijuana bubble? The warning signs are there

Pot stocks have a certain appeal: They're new, they're different and they invite puns, writes David Berman. As investments, though, their appeal is harder to see. Valuations have risen to the point where it is only natural to wonder if the sector has inflated to bubbly levels, leaving new investors with a big question: Have you thought this through? Trouble is, the enthusiasm driving pot stocks is now miles ahead of reality, making the sector look like a dangerously inflated bubble with absurd valuations.


How to dissect the earnings of marijuana producers

A quick look at the results of some of Canada's emerging cannabis companies shows some remarkable profitability for early-stage businesses. But a deeper dive into the financials shows the companies' results are more complex to assess than at first blush, writes David Milstead. The culprit, if you will, is that Canadian public companies, both on the TSX and Vancouver's venture exchange, use International Financial Reporting Standards (IFRS). And these accounting rules have special requirements for natural resources – such as marijuana plants – that can greatly skew the companies' bottom-line profitability.


These U.S. sectors have the best profit momentum as earnings season begins

The U.S. earnings season kicks off Thursday with JPMorgan and, according to analyst earnings revisions, semiconductors, retail and banking stocks are the hottest sectors heading into the latest cluster of quarterly results. Scott Barlow takes a deeper look at specific companies driving the biggest improvements in sector outlooks.


Two corporate battles investors would be wise to bet on

In a market where just about every stock looks fully priced, Elliott Management Corp. says it's spotted several cases where a management shake-up could unlock big gains for shareholders, writes Ian McGugan. Given Elliott's track record, investors who don't mind risk – or conflict – may want to bet on the chance that the big New York-based hedge fund is right. Elliott's newest target is BHP Billiton Ltd., the world's largest miner, which received a letter on Monday outlining the fund's aggressive makeover proposal. Yet another high-profile target is Arconic Inc., the New York-based maker of car and airplane parts that was carved out of aluminum giant Alcoa late last year.


Rob Carrick's 2017 ETF Buyer's Guide: Best U.S. equity funds

You can fix a lot of what's wrong with the Canadian stock market by getting some exposure to U.S. stocks, writes Rob Carrick. Canada is loaded with resource stocks and financials and has only token exposure to technology and health care. The U.S. market is loaded with tech and health-care stocks, and has only a small weighting in energy and mining stocks. The Canadian and the U.S. markets just go together, especially when you buy them using exchange-traded funds. In this edition of the ETF Buyer's Guide, we look at core U.S. equity funds that let you buy the broad U.S. market in a single convenient package. Canadian equity funds were covered on March 11 and Canadian bond funds on March 25.


Are fees included in my fund's returns?

Performance data published by mutual funds and exchange-traded funds are after deducting the management expense ratio (MER), which includes the fund's management fee, operating expenses and taxes. That's only fair, considering these costs directly affect the investor's return, writes John Heinzl. The MER is expressed as a percentage of the fund's average assets for the year. However, instead of being subtracted annually in one shot, the MER is usually deducted on a daily (prorated) basis and is reflected in the net asset value of the fund. Fund returns are also reported after trading costs, which are reflected in the trading expense ratio (TER). He explains more in his Investor Clinic column.


Canadian tech IPO drought to end as Real Matters files to go public

Real Matters Inc. is set to end Canada's two-year drought for technology IPOs after filing late Monday to go public on the Toronto Stock Exchange. The Markham, Ont-based mortgage services firm filed a preliminary prospectus to raise an undisclosed amount on the Toronto Stock Exchange in a deal being led by underwriters BMO Nesbitt Burns and Infor Financial Group. The last Canadian tech company to go public was Shopify Inc. in May, 2015.


Other subscriber-only reading:

CEO at Canopy Growth, Canada's largest marijuana stock, is selling

Fifteen companies with recent insider buying activity

Thirteen stocks insiders are selling


Number Crunchers

Twelve large-cap Canadian dividend stocks offering high free cash flow


Ask Globe Investor

Question: If a fund has a reinvested capital gains distribution, why does the investor have to increase his or her adjusted cost base (ACB)? And why is there no adjustment to the ABC if the fund distributes the capital gain in cash?

Answer:The best way to explain this is to look at two scenarios where the fund has a capital gain.

Scenario #1: Capital gain distributed in cash

Say you buy XYZ fund for $9 a unit. The stocks in XYZ later rise, and the unit price climbs to $10. The fund then decides to distribute a capital gain of $1 in cash. You receive $1 in cash, pay capital gains tax of (about) 25 cents and put 75 cents in the bank.

Because $1 in cash has left the fund, XYZ's unit price must drop by $1, back to the original $9. If you then sell your unit for $9, you will have no capital gain on the sale (because your ACB and sale price are both $9) and there is no further tax to pay. Net result: you have $9.75 (The $9 from selling your unit and the 75 cents in the bank).

Scenario #2: Capital gain reinvested in the fund

As above, you buy XYZ for $9 a unit and the price rises to $10. But instead of paying you $1 in cash, the fund declares a reinvested capital gains distribution of $1. You pay (about) 25 cents in tax but receive no cash.

In this case, because no capital actually left the fund, XYZ's unit price does not change after the reinvested distribution. It remains at $10. If you were to then sell your unit for $10 (using your original ACB of $9), you would have a second capital gain of $1 and pay tax again of 25 cents. In this case you would be paying tax twice and that would not be fair.

That's why, when a distribution is reinvested, you must increase your ACB. Your ACB in this case would not be $9; it would be the original $9 plus the $1 reinvested distribution, for a total ACB of $10. If you then sell your unit for $10, you would have no capital gain and no further tax to pay (because your ACB and sale price are both $10) and you would end up with $9.75 (the $10 sale proceeds minus the 25 cents in tax you paid on the distribution). Note that this is same net result as in scenario #1 (as it should be since in both cases there is a $1 capital gain, the only difference being one is distributed in cash and the other remains in the fund).

Now go back to scenario #1. If you had increased your ACB to $10, you would have had a capital gain of $1 on the sale of XYZ (for $9) and you would have had to pay 25 cents in tax a second time. That's why you don't increase your ACB when a capital gain is distributed in cash.

-- John Heinzl

Do you have a question for Globe Investor? Send it our way via this form. Questions and answers will be edited for length.



What's up in the days ahead

National Bank of Canada has delivered some bad news over the past 18 months: It has diluted investors by issuing new shares, taken an embarrassing writeoff on an investment and rattled observers with its large exposure to the troubled energy sector. But the stock has soared. David Berman will explain the reasons why, and what investors should do about it, in Wednesday's Globe Investor. Later in the week, Tim Shufelt will take a look the surprising transformation taking shape in emerging markets and what it means for TSX investors.

Click here to see the Globe Investor earnings and economic news calendar.


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Compiled by Gillian Livingston

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