The media always seems rife with reports about unscrupulous behavior on Wall Street. This week, it was the PFGBest scandal, with $220 million in client cash missing from the broker as the founder attempted suicide. Before that it was MF Global, the London Whale at JPMorgan Chase (NYSE:JPM) … the list goes on.
Scam artists on a big scale seem to make the biggest headlines. However, there is the persistent and real threat of smaller scams being perpetrated against investors every day on a smaller scale.
Ever seen the 2000 movie Boiler Room? Well, that kind of scene isn’t a fiction. And it doesn’t always end with a big raid. And sometimes, the villains don’t get prosecuted.
To be clear, the Securities and Exchange Commission isn’t asleep on the job. Here’s an SEC bust from May 2012 regarding a $35 million international scam and a release about a January 2012 raid in Florida on penny stock manipulators who were caught.
But for every cockroach you see, there are dozens more hiding in the walls.
Penny stocks and microcaps are attractive to some investors because of the big profit potential. But they also are a playground for crooks. These thieves prey on investors in the following ways:
- False promises: Fluffy marketing about your product is one thing, but faking contracts or alluding pending deals that never will transpire are another. Typically, companies have products that will “revolutionize” an industry or have growth potential that makes them “the next Apple.” Take everything you read with a fistful of salt in the market in general — especially when it comes to penny stocks and microcaps.
- Celebrity spokesmen: Penny stocks aren’t above paying someone to tout their company. Daniel “Rudy” Ruettiger of Notre Dame walk-on fame was convicted of fraud for his antics in a tiny sports drink company called, obviously, Rudy. Rapper 50 Cent was paid to talk up a penny stock on Twitter. Clearly, this is a big warning sign.
- Pump-and Dumpers: The previous two penny stock scammers feed into this third: unscrupulous investors who try to inflate a microcap’s price so they can abandon ship at the top and make a fortune — while others ride it down to oblivion. This is most easily achieved in microcaps with thin volume, since it’s easy to move the market with a stock that trades only a few thousand shares a day.
So how do you protect yourself from penny stock scammers? The simplest way is to never trade microcaps or penny stocks. I have written extensively on the topic (see this July 2012 post about microcaps, this April 2012 post about low volume and this January 2012 post about penny stock risks), and many in financial media agree with me.
Stick with stocks that trade more than 100,000 shares daily, have a market cap of over $500 million and trade on major exchanges. There are a few exceptions to this rule, but better safe than sorry.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves did not own a position in any of the aforementioned securities.