Penny Stocks' Risks and Rewards
Penny stocks come with high risks and the potential for extraordinary
returns, so investing in them requires care and caution. Penny stock
companies are often headed for bankruptcy or are highly overleveraged,
because of that investing in penny stocks is risky. There are two ways to
make money with penny stocks, but they’re both high risk. Below is a
breakdown on the risk and rewards of penny stocks. (For related reading,
see: What is the Difference Between a Penny Stock and a Small-Cap Stock?)
The Lowdown on Penny Stocks
Penny stocks can be defined in many different ways. Most people
logically assume that penny stocks refer to stocks trading for less than
$1. However, the SEC defines penny stocks as stocks trading for less
than $5. Generally, penny stocks trade on the Pink Sheets or FINRA’s
OTC Bulletin Board (OTCBB). Both exchanges should be approached
with extreme caution, but even more so the Pink Sheets since these
companies aren’t required to file with the Securities and Exchange
Commission(SEC). (For more, see: Use Caution Trading Pink Sheet
Stocks.) And don’t get your hopes up with stocks trading on the OTCBB.
It’s still difficult to find information to formulate a logical conclusion on
whether or not the company is likely to survive, let alone thrive.
Whether the penny stock trades on Pink Sheets or the OTCBB, it
will be challenging to find credible information. Keep in mind that there
are no minimum standards for a company to remain on the Pink Sheets
or the OTCBB. (For more, see: What Does it Mean When a Stock Trades
on the Pink Sheets or the OTCBB?)
Penny stock scammers deceive by luring inexperienced investors into
investing in cheap and worthless stock and taking their money. Be
careful not to get caught up in one of these common penny stock scams.
Below, are examples of other common penny stock scams you should avoid.
Pump-and-Dump Schemes
This fraud happens all the time. Promoters drum up interest in a
scarcely known or unknown stock. Inexperienced investors buy up
the shares, pumping the price. Once the stock has reached a certain
inflated price, the bad guys sell, or dump, the stock at a huge profit. In
turn, investors are left high and dry. These pump-and-dump schemes
are often distributed through free penny stock newsletters, where the
publisher is paid to list these unpromising and hyped-up stocks. If you
get one of these newsletters, read the fine print on its website. You may
notice that the companies or promoters are paying the author of the
newsletter to feature them.
Short-and-Distort
This is the opposite of the pump-and-dump. Scammers use short-sell to
make a profit. Shorting works when the investor borrows shares and
immediately sells them in the open market at a high price, hoping the
company stock falls so he can later scoop up sold shares at a lower price.
He then returns these shares to the lender and nets a profit. Penny stock
scammers short-sell a stock and make sure the stock falls by spreading false
and damaging rumors about the company. Investors hold a losing stock, while
short-sellers make money through their short-selling trick.
Reverse Merger
Sometimes a private company merges itself with a public company, so it
can become publicly traded without the hassle and expense of going through
more traditional methods. This makes it easy for the private company to falsify
its earnings and inflate its stock prices. While some reverse mergers are legit,
you can catch a reverse merger by reviewing the business’ history and detecting
spotty activity in its merger.
Mining Scams
Gold, diamonds, and oil have always been alluring. One of the most famous
mining scams was Bre-X, in the mid-1990s, when founder David Walsh falsely
claimed his company found a massive gold mine in Burma. Speculation soared
fast until the company’s valuation, all in penny stocks, was worth $4.4 billion by
1997. When the company collapsed, most investors lost everything.
The Guru Scam
Guru adds are commonplace, and sadly people fall for them easily. These
false ads usually show you how the ‘expert’ became rich through a special
‘secret’ and acquired materialistic success, such as glitzy cars, lakefront
houses, and boats. The ‘expert’ promises to share his penny stock trading
secrets with you for a ‘one-time’ low sum. If someone dubs himself a guru or
promises to make you rich, trash that email or envelope. There is no “one-size
-fits-all" path to riches, and certainly not in the stock market. In a similar way,
avoid those schemes that promise you unlimited success from a once-in-a-lifetime
product or invention that claims to be the next Thomas Edison invention.
"No Net Sales" Scams
This is when scammers sell shares of a company, stipulating that investors
cannot sell the shares for a certain amount of time. The investors buy because
they are fooled into thinking there is huge and continuing demand for this stock.
By the time the U.S. Securities and Exchange Commission (SEC) shutters these
companies, investors are left with nothing.
Offshore Scams
The U.S. Securities and Exchange Commission says that companies who
operate outside the United States do not need to register their shares when
they are selling to offshore investors. Penny stock scammers love this. They
buy unregistered and cheap company shares from an offshore location and
sell the stock to investors in America at an inflated price. This influx of
unregistered shares causes the company’s stock price to drop. Thieves make
huge money, while U.S. investors are left with little, if anything, to pocket.
How To Avoid Scams
Certainly, the penny stock world is rife with market manipulation, fraud
and chicanery, but investors should know that such abusive practices aren't
the exclusive domain of penny stocks and micro-caps by any means, as the
cases of scandal-ridden companies like Enron and WorldCom well prove. That
said, how can you avoid being scammed by dishonest penny stock promoters
who are out to make a fast buck? Here are some suggestions:
Know the difference between promotion and research. Promoters routinely
hire newsletter writers to write flattering reports about their stocks. Many of
these writers make a convincing case for investing in dud penny stocks, using
hyperbole, outlandish projections and, in some cases, deliberate distortion, as
these promotional pieces look very similar to sell-side research reports. The penny
stock investor has to learn to distinguish between stock promotion and legitimate
equity research. One way is to read the "disclosures" section at the end of the report,
and see whether the writer is being directly compensated (often in a combination of
cash and stock) for the report by the company they're recommending. If that's indeed
the case, this is essentially an advertisement, not an actual research report.
How credible is the company's management? A company's success depends
on the quality of its management, and penny stock companies are no different.
Although you're unlikely to find a Steve Jobs running a penny stock company,
you should still delve into management's track record to determine whether
company executives and directors have had any notable successes or failures,
regulatory or legal issues and so forth.
How do the financials look? Although penny stocks generally don't furnish
in-depth financial information, it won't hurt to check the financial statements
the company does release. Scrutinize the balance sheet to learn if the
company has any substantial debt or liabilities outstanding, as well as its
amount of net cash on hand. If the income statement shows huge growth
in revenues of late, that's one promising sign
What's the quality of disclosure? The more disclosure the company
provides, the better, as that indicates a greater level of corporate
transparency. For instance, the OTC Markets Group divides its securities
into a three-tier marketplace: OTCQX (the top tier), OTCQB (middle tier)
and OTC Pink, based on the integrity of a company's operations, its level
of disclosure and its investor engagement. Since OTC Pink company reporting
can be spotty, OTC Markets Group further segments that group, based on the
quality and quantity of information provided, into Current Information, Limited
Information, and No Information. Obviously, investing in a company with limited
or no information is best avoided, as the phrase "no news is good news" doesn't
apply in the penny stock world. In addition, stocks for which OTC Markets Group
advises investors to exercise additional care and thorough due diligence typically
flash a skull-and-crossbones "Caveat Emptor" sign. Penny stocks may earn this
symbol for a number of reasons: the company or its insiders may be under
investigation for fraudulent or criminal activity, or the company may be involved in
such dubious promotional activities as spam emails.
Is the business plan achievable? Investors should evaluate whether the
company's business plan is achievable and if it actually has the asset base
it professes to have. Recall the infamous case of Bre-X, the Canadian junior
miner that in the 1990s claimed to have found one of the world's biggest gold
mines in Busang, Indonesia: a story that turned out to be a colossal fraud
(For more, read: The Biggest Stock Scams Of All Time). Before it was found
out, Bre-X shares climbed from 12 cents to C$280. Its collapse in 1997 wiped
out C$3 billion in market value, and likely a fair share of penny stock investors.
Penny stocks come with high risks and the potential for extraordinary
returns, so investing in them requires care and caution. Penny stock
companies are often headed for bankruptcy or are highly overleveraged,
because of that investing in penny stocks is risky. There are two ways to
make money with penny stocks, but they’re both high risk. Below is a
breakdown on the risk and rewards of penny stocks. (For related reading,
see: What is the Difference Between a Penny Stock and a Small-Cap Stock?)
The Lowdown on Penny Stocks
Penny stocks can be defined in many different ways. Most people
logically assume that penny stocks refer to stocks trading for less than
$1. However, the SEC defines penny stocks as stocks trading for less
than $5. Generally, penny stocks trade on the Pink Sheets or FINRA’s
OTC Bulletin Board (OTCBB). Both exchanges should be approached
with extreme caution, but even more so the Pink Sheets since these
companies aren’t required to file with the Securities and Exchange
Commission(SEC). (For more, see: Use Caution Trading Pink Sheet
Stocks.) And don’t get your hopes up with stocks trading on the OTCBB.
It’s still difficult to find information to formulate a logical conclusion on
whether or not the company is likely to survive, let alone thrive.
Whether the penny stock trades on Pink Sheets or the OTCBB, it
will be challenging to find credible information. Keep in mind that there
are no minimum standards for a company to remain on the Pink Sheets
or the OTCBB. (For more, see: What Does it Mean When a Stock Trades
on the Pink Sheets or the OTCBB?)
Penny stock scammers deceive by luring inexperienced investors into
investing in cheap and worthless stock and taking their money. Be
careful not to get caught up in one of these common penny stock scams.
Below, are examples of other common penny stock scams you should avoid.
Pump-and-Dump Schemes
This fraud happens all the time. Promoters drum up interest in a
scarcely known or unknown stock. Inexperienced investors buy up
the shares, pumping the price. Once the stock has reached a certain
inflated price, the bad guys sell, or dump, the stock at a huge profit. In
turn, investors are left high and dry. These pump-and-dump schemes
are often distributed through free penny stock newsletters, where the
publisher is paid to list these unpromising and hyped-up stocks. If you
get one of these newsletters, read the fine print on its website. You may
notice that the companies or promoters are paying the author of the
newsletter to feature them.
Short-and-Distort
This is the opposite of the pump-and-dump. Scammers use short-sell to
make a profit. Shorting works when the investor borrows shares and
immediately sells them in the open market at a high price, hoping the
company stock falls so he can later scoop up sold shares at a lower price.
He then returns these shares to the lender and nets a profit. Penny stock
scammers short-sell a stock and make sure the stock falls by spreading false
and damaging rumors about the company. Investors hold a losing stock, while
short-sellers make money through their short-selling trick.
Reverse Merger
Sometimes a private company merges itself with a public company, so it
can become publicly traded without the hassle and expense of going through
more traditional methods. This makes it easy for the private company to falsify
its earnings and inflate its stock prices. While some reverse mergers are legit,
you can catch a reverse merger by reviewing the business’ history and detecting
spotty activity in its merger.
Mining Scams
Gold, diamonds, and oil have always been alluring. One of the most famous
mining scams was Bre-X, in the mid-1990s, when founder David Walsh falsely
claimed his company found a massive gold mine in Burma. Speculation soared
fast until the company’s valuation, all in penny stocks, was worth $4.4 billion by
1997. When the company collapsed, most investors lost everything.
The Guru Scam
Guru adds are commonplace, and sadly people fall for them easily. These
false ads usually show you how the ‘expert’ became rich through a special
‘secret’ and acquired materialistic success, such as glitzy cars, lakefront
houses, and boats. The ‘expert’ promises to share his penny stock trading
secrets with you for a ‘one-time’ low sum. If someone dubs himself a guru or
promises to make you rich, trash that email or envelope. There is no “one-size
-fits-all" path to riches, and certainly not in the stock market. In a similar way,
avoid those schemes that promise you unlimited success from a once-in-a-lifetime
product or invention that claims to be the next Thomas Edison invention.
"No Net Sales" Scams
This is when scammers sell shares of a company, stipulating that investors
cannot sell the shares for a certain amount of time. The investors buy because
they are fooled into thinking there is huge and continuing demand for this stock.
By the time the U.S. Securities and Exchange Commission (SEC) shutters these
companies, investors are left with nothing.
Offshore Scams
The U.S. Securities and Exchange Commission says that companies who
operate outside the United States do not need to register their shares when
they are selling to offshore investors. Penny stock scammers love this. They
buy unregistered and cheap company shares from an offshore location and
sell the stock to investors in America at an inflated price. This influx of
unregistered shares causes the company’s stock price to drop. Thieves make
huge money, while U.S. investors are left with little, if anything, to pocket.
How To Avoid Scams
Certainly, the penny stock world is rife with market manipulation, fraud
and chicanery, but investors should know that such abusive practices aren't
the exclusive domain of penny stocks and micro-caps by any means, as the
cases of scandal-ridden companies like Enron and WorldCom well prove. That
said, how can you avoid being scammed by dishonest penny stock promoters
who are out to make a fast buck? Here are some suggestions:
Know the difference between promotion and research. Promoters routinely
hire newsletter writers to write flattering reports about their stocks. Many of
these writers make a convincing case for investing in dud penny stocks, using
hyperbole, outlandish projections and, in some cases, deliberate distortion, as
these promotional pieces look very similar to sell-side research reports. The penny
stock investor has to learn to distinguish between stock promotion and legitimate
equity research. One way is to read the "disclosures" section at the end of the report,
and see whether the writer is being directly compensated (often in a combination of
cash and stock) for the report by the company they're recommending. If that's indeed
the case, this is essentially an advertisement, not an actual research report.
How credible is the company's management? A company's success depends
on the quality of its management, and penny stock companies are no different.
Although you're unlikely to find a Steve Jobs running a penny stock company,
you should still delve into management's track record to determine whether
company executives and directors have had any notable successes or failures,
regulatory or legal issues and so forth.
How do the financials look? Although penny stocks generally don't furnish
in-depth financial information, it won't hurt to check the financial statements
the company does release. Scrutinize the balance sheet to learn if the
company has any substantial debt or liabilities outstanding, as well as its
amount of net cash on hand. If the income statement shows huge growth
in revenues of late, that's one promising sign
What's the quality of disclosure? The more disclosure the company
provides, the better, as that indicates a greater level of corporate
transparency. For instance, the OTC Markets Group divides its securities
into a three-tier marketplace: OTCQX (the top tier), OTCQB (middle tier)
and OTC Pink, based on the integrity of a company's operations, its level
of disclosure and its investor engagement. Since OTC Pink company reporting
can be spotty, OTC Markets Group further segments that group, based on the
quality and quantity of information provided, into Current Information, Limited
Information, and No Information. Obviously, investing in a company with limited
or no information is best avoided, as the phrase "no news is good news" doesn't
apply in the penny stock world. In addition, stocks for which OTC Markets Group
advises investors to exercise additional care and thorough due diligence typically
flash a skull-and-crossbones "Caveat Emptor" sign. Penny stocks may earn this
symbol for a number of reasons: the company or its insiders may be under
investigation for fraudulent or criminal activity, or the company may be involved in
such dubious promotional activities as spam emails.
Is the business plan achievable? Investors should evaluate whether the
company's business plan is achievable and if it actually has the asset base
it professes to have. Recall the infamous case of Bre-X, the Canadian junior
miner that in the 1990s claimed to have found one of the world's biggest gold
mines in Busang, Indonesia: a story that turned out to be a colossal fraud
(For more, read: The Biggest Stock Scams Of All Time). Before it was found
out, Bre-X shares climbed from 12 cents to C$280. Its collapse in 1997 wiped
out C$3 billion in market value, and likely a fair share of penny stock investors.
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