As the stock market continues to fluctuate, there are many stories about investors who put a small amount of money into a stock and watched their investment soar to hundreds of thousands of dollars.

Unfortunately, an increasing number of people think the “hot stocks” to buy are penny stocks. Who can resist a sales pitch that begins by telling prospective investors that they would be multimillionaires by now if they had bought Microsoft or Intel when they were struggling companies and the prices of their stock were worth only a few bucks?

The allure of these millions is what has spurred the increasing popularity of penny stocks. The promoter who pitches penny stocks never discloses that he or she is referring to Microsoft or Intel’s split-adjusted price. (A stock split is an increase in the number of outstanding shares of a company’s stock in which each shareholder’s equity remains the same. The market price per share drops proportionately. It is usually done to make a stock with a high per-share price more accessible to small investors.) Few great companies were ever penny stocks.

A penny stock is defined as a stock whose price is less than $5 a share. Most of these companies have limited assets and most of the time their stock activity is as little as a few thousand shares or less per day, or may go for days without trading at all. In many cases, the companies have no history of operations or earnings, and their entire business may still be in the idea stage.

The stocks usually trade on the Over the Counter Bulletin Board (OTCBB) and the Pink Sheets. The OTCBB is an electronic quotation system that allows brokers to enter bids and ask prices. The bid is the highest price any buyer is willing to pay for a given security at a given time and the lowest price that any investor has declared that he or she will sell. The Pink Sheets are updated daily by the National Quotation Bureau and are available on the Internet to brokers/dealers, issuers, and investors. Unlike other trading markets, such as the New York Stock Exchange or Nasdaq, the Pink Sheets or the OTCBB do not have minimum-listing requirements. This means that companies with stock prices of just a few pennies can get listed on the OTCBB or the Pink Sheets.

Where do you find out more about a company if you are interested in investing in a penny stock? Any company that has more than 500 shareholders and $10 million in assets is required to file annual and quarterly reports with the Securities and Exchange Commission (SEC). Many penny-stock companies do not have to file the reports with the SEC because they do not have the requisite number of shareholders or level of assets.

The lack of public information is one of the biggest reasons the penny-stock market is ripe with fraud. Public information is one of the most important ingredients in making an informed investment decision. An investor cannot invest prudently if he or she does not have crucial financial information about a company. Many of these companies have no earnings history, which usually means no securities analyst or financial news media scrutinizes the stock. The end result is that there is an absence of unbiased information in the marketplace. Since penny stocks usually trade only a few thousand shares a day, if at all, they can be utterly illiquid. This can make it close to impossible to sell if an investor has to sell quickly.

There are 3,910 securities quoted exclusively on the Pink Sheets; 1,862 quoted exclusively on the OTCBB; and 1,917 quoted on both. That is a lot of companies without the information the investors need to make wise investment decisions. Let the buyers beware.

Since penny stocks have low trading prices, it is very easy for a defrauder to gain control of outstanding shares. Once a defrauder secures a large percentage of the outstanding shares, it becomes quite easy to manipulate the stock’s price. Penny stocks are the market’s lottery ticket. It is an agent of financial decay among those who have not been educated about investing.

If penny stocks present such little opportunity to long-term investors, why do they attract attention? Many novice investors will buy them, not having been educated that bankruptcy and penny stock companies travel together. The combination of the opportunity to hold large share positions and the appearance of unlimited upside potential draws new investors into this most highly speculative form of investing. Investors may be attracted to them because they can buy many shares for little money. If you were investing $2000, for example, you could buy 200 shares of a stock trading at $10 per share. But you could buy 20,000 shares of a penny stock trading at 10 cents a share. Of utmost importance is the dollar amount invested and the percentage change, not the number of shares owned.

Penny stocks are not appealing for many investors. Recent reports have noted that penny-stock fraud bilks investors out of approximately $2 billion a year. While no system is infallible, a prudent strategy for most investors is the simple step of writing off penny stocks completely.

Here are some principles to follow when making any investment decision:

• Always do your homework. Never invest based solely on a “tip” someone gives you. Never base an investment decision solely on what you read on an Internet bulletin board or hear in a chat room.

• Watch out for certain catchphrases such as “risk-free” and “guaranteed return”. Watch out for promoters who tell you this is a “once-in-a-lifetime opportunity”, and “this is an opportunity to get in on the ground floor”.

• Never succumb to high-pressure sales tactics. It’s your money. Take time to fully research each investment decision.

• Don’t invest in something you don’t understand.

• If something sounds too good to be true, it probably is. So watch out for promises that sound like the next Microsoft.

You should always make sure that you consult with your investment professional before you buy stocks on your own.

Jodye Deal is the owner of Gazelle Associates (www.gazelleassociates.com),
an investment planning firm based in Virginia. Send questions on investing
to investing@gazelleassociates.com or call (703) 995-4491.

Jodye Deal, Owner
Gazelle Associates
www.gazelleassociates.com
Phone: (703) 995-4491
Fax: (435) 806-7173