Penny stocks are a popular way for many folks to invest.
The risks of penny stock investing are so acute, in fact, that the U.S. Securities and Exchange Commission has a host of resources and publications to ensure investors know what they are getting into. One such SEC webpage on penny stock rules warns the following (emphasis theirs, not mine):
“Penny stocks may trade infrequently, which means that it may be difficult to sell penny stock shares once you own them. Moreover, because it may be difficult to find quotations for certain penny stocks, they may be difficult, or even impossible, to accurately price. For these, and other reasons, penny stocks are generally considered speculative investments. Consequently, investors in penny stocks should be prepared for the possibility that they may lose their whole investment (or an amount in excess of their investment if they purchased penny stocks on margin).”
This is only the beginning of your risk if you invest in penny stocks, however.
Even worse than buying shares of a legitimate company that goes bankrupt is the idea of plowing your hard-earned cash into a penny stock scam, where no real business actually exists.
That’s what happened to investors last year who bought into a sophisticated penny stock scam ring, and were fleeced out of $140 million because they believed in a “revolutionary” fertilizer company called Resource Group International.
Think the 2000 movie Boiler Room. Well, that kind of stuff isn’t fiction.
I personally don’t ever invest in penny stocks because of the volatility and risk. Nor do I recommend any other investors do so because there are plenty of alternatives out there with better liquidity and transparency than microcaps trading on the pink sheets.
But hey, I also don’t smoke cigarettes or race motorcycles. What you choose to do with your money, on your time, is your own business … and if you’re comfortable with the risks, then it’s not my place to judge.
If you are investing in penny stocks, though, here are a few tips I think you should review to ensure your investments stay out of the hands of fraudsters:
Beware False Products, Not Just False Promises: Fluffy marketing about your product is one thing, but faking contracts or referring to a big deal that never happened are other matters — and against the law. Many companies claim to have products that will “revolutionize” an industry, and false promises are sadly just a way of the advertising world. But research what you can, where you can to ensure that the products themselves are real and that revenue actually exists somewhere.
Shun Celebrity Investment Tips: Penny stocks aren’t above paying someone to tout their company. Daniel “Rudy” Ruettiger of Notre Dame walk-on fame paid $382,866 (though did not have to admit guilt) in a settlement 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. Again, marketing is one thing … but there’s a big difference between William Shatner telling you to book a flight on Priceline.com (PCLN) and William Shatner taking to the airwaves to tell you explicitly to invest in PCLN stock.
Pump-and Dump Protection: Ruettiger’s scam feeds into this third one: unscrupulous investors who try to inflate a microcap’s price so they can dump shares at the top and make a fortune — right before the price crashes again. This is most easily achieved in microcaps with thin volume, because it’s easy to move the market with a low-priced stock that trades only a few thousand shares a day. It’s an increasingly popular tactic — a Trustwave report recently showed that penny stock-touting messages accounted for “16% of unwanted email in 2013, up from less than 1% the year before,” according to MarketWatch. You can protect yourself by looking for more liquid stocks that trade on higher volume, and even then, it’s a good idea to use a limit order to prevent buying shares at a higher price than you expected.
Again, penny stocks are a highly risky asset class where even reasonably legitimate companies can go bankrupt. It is on every investor to do his or her own research and look seriously at microcap stocks before simply buying in based on a narrative of once-in-a-lifetime opportunities.
And remember this above all: Over-the-counter and pink-sheet stocks are still subject to SEC oversight, and by law have to file certain documentation. That is your best hope of getting the real story.
Here’s an excerpt:
“The Company was formed by Nishon Petrossian, the initial director, for the purpose of creating a corporation which could be used to consummate a merger or acquisition. Mr. Petrossian serves as President, Secretary, Treasurer and Director. Mr. Petrossian determined next to proceed with filing a Form S-1. Mr. Petrossian has no specific experience, qualification, attributes or skills to perform as a director of a blank check company nor in the acquisition of acquisition candidates.”
Got that? A guy with zero experience or skill wants to raise money to acquire another company … nice dream!
It gets even better, with clauses that allowed Petrossian sole discretion over executive compensation (just his, of course, since he serves in all four senior roles), and furthermore that “The Offering Price of the Shares bears no relation to book value, assets, earnings, or any other objective criteria of value. They have been arbitrarily determined by the Company.”
What could go wrong?
Thankfully, Great Idea Corp is no longer out there — because, as should be evident, it was a penny stock doomed to go to zero.
But it is highly instructive that a company like filed with the SEC at all.
The best way to protect against penny stock losses — either through fraud or just bonehead ideas — is to actually know where the money is going. If you don’t take the time to read through documents or at least poke around the Internet, expect to get burned or ripped off.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at email@example.com or follow him on Twitter via @JeffReevesIP.