Spotting Sharks Among Penny Stocks

By Andrew Beattie AAA

For every publicly traded corporations with market capitalization in the hundreds of millions and billions, there are thousands of smaller companies with much more modest market caps. Because these companies have smaller operations and more risks, they trade at only a fraction of the price of their much larger counterparts. These are, of course, the infamous penny stocks. This article will look at some of the dangers that lurk in penny stocks trading.

The Myth Of Evolution
One thing that keeps people dabbling in penny stocks is the belief that these corporations will evolve into firms that will become much like their larger counterparts. This has happened, but not as regularly as penny stock proponents would have you believe.

Many public firms simply defer going public until they have grown large enough for it to be worthwhile. Until that time, they will usually raise money through private investors or corporate loans along with their regular operations. Generally, these companies do not need an initial public offering (IPO) to fund an expansion. The larger a company becomes, the more practical it is to raise funds through a public offering, because although equity is seen as a relatively more expensive form of financing, it often becomes necessary for larger companies.

Good Intentions?
If a company is offering its stock at the penny level, it is usually for one of the following reasons. First, the company may be on the cusp of a large expenditure, and it believes that the money raised by an IPO will be enough to finance it. Second, the company may have reached the apex of its growth and it wants to change its tax structure or disperse the profits.

There are also less noble reasons for a company to go through an IPO process when it is still quite small. Sometimes a company is talked into an overpriced and overhyped IPO by penny stock brokerage firms that want to make a quick dollar from unwary investors. An IPO could also be an attempt by the company's owners to offload their ownership to investors because they see little promise in the company's future.

Oranges and Apples
It is important to remember that within penny stocks, there is a wide range of companies. You can find an oil prospecting company with a recognizable corporate structure right next to a family-run organic farm that specializes in cabbage. Some of those companies may allow investors to have a say in who is running the show, and some may be one-man operations that suffer terribly when the founder retires or dies. And while larger companies generally strive to please investors, penny stock companies may pay no mind to their investors at all.

The Bait
Not many value investors spend their time in penny stocks. Although a well-managed penny stock company may see good returns over the years, it is much more difficult to get full disclosure and the rules that apply to penny stocks are much looser. These companies do not face the same standards as large firms, are required to file with the Securities and Exchange Commission (SEC) less frequently and have limited requirements for listing.

What lures investors into the oceans of penny stocks is the dream of buying 1,000 shares for $0.50 and then later selling them for $5 or some similarly lucrative transaction. Unfortunately, that ocean is full of sharks that know exactly what you're looking for.

The Bite
Some people think that brokerage firms that specialize in penny stocks are often just a step up from a guy with a bat waiting to rob someone in a dark alley. Successful companies don't need people to cold call and talk up their stocks. Penny stockbrokers engage in a mixture of cold calling and targeted sells. They often have a collection of leads, people who have had a history of buying into poor investments over the phone or who have given their information to someone who turned around and sold it.

Using this list, the stockbrokers will call prospective marks and introduce themselves. Soon after, be it a day or a week, they will call again with a chance to get in on the ground floor of a stock that is set to rocket away. This will prove to be a stock that they have been pumping up in message boards, emails, newsletters, etc. Then, when investors buy in, the firm and its partners get out and leave a gaping wound in the investors' portfolios. These firms are also known to take their pound of flesh in the form of high commissions.

These firms, and the brokers that support them, will often use techniques such as advertising in mass emails. You may see mailings in your account about the latest greatest stock that is set to return 1,000%. In all cases, without doubt, it is a penny stock, and one you probably should avoid.

Multiple Victims
Sometimes the companies involved in these swindles are complicit, but even honest companies find their stocks targeted by unscrupulous penny stockbrokers. These sharks may take an innocent company that has had a few good years and make false publications or claims that "insiders" have said it is poised for a leap. When the brokers pull out, they have not only ripped off investors but also ruined the reputation of an otherwise stalwart company.

Blood in the Water
If an investor has the poor judgment to get involved with penny stockbrokers, he or she may find a permanent target painted on his or her back. Because of the profits and commissions involved, these brokers will persist with their calls until they get your check - after that the calls will dry up and the number may even change. Many of the sharks in penny stock brokerages have securities violations on their records, but it is their ability to sell that keeps other firms hiring them - and it is dishonest profits that keep penny stock brokerage firms in business.

The Bottom Line
By and large, attempts to regulate penny stocks have been thwarted. The low prices make them ideal for manipulation because a few false cents per share can mean thousands if you hold most of the shares. The internet has also offered a whole new medium by which to cheat investors. For every site that exposes penny stock fraud, there are hundreds of sites espousing one undiscovered treasure or another. The best way to avoid getting swindled in the penny stocks is just to stay out of the water - if you don't swim, you won't be bitten.

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