Fool.com: The Lure of Penny Stocks [Foolish Four] February 8, 2000

FOOLISH FOUR PORTFOLIO
The Lure of Penny Stocks

By Barbara Eisner Bayer (TMF Venus)
February 8, 2000

Every day, new investors are seduced by the lure of penny stocks. On the surface, penny stocks make sense. Just imagine -- you invest in a stock that's trading for $0.25 a share. When it reaches $0.50 a share, you've doubled your money. Heck, you can find $0.25 lying in the middle of the street... it seems easy for a stock to change that much in value.

On the other hand, if a company like Microsoft is trading for $90 a share, the stock would have to reach $180 before you'd double your money. That's a lot of quarters! Sure seems like it's a shorter route to riches if you invest in the $0.50 stock, yes?

Not necessarily. A penny for your thoughts makes sense; a penny for your stocks might not make cents.

What exactly is a penny stock?

Penny stocks are at the other end of the investing spectrum from our blue-chip Foolish Four stocks. We define a penny stock as any stock that sells for under $5 or is listed on the Over the Counter Bulletin Board (OTCBB) or the Pink Sheets.

The OTC Bulletin Board is an electronic listing of stocks not meeting the minimum net worth requirements of the Nasdaq. Lower on the investing food chain are companies that trade on the Pink Sheets, which don't even meet the minimal criteria for capitalization and number of shareholders that are required by the OTCBB. (Trivia note: The "pink sheet" designation is a holdover from the old days, when the quotes for these stocks were printed on pink paper to distinguish them from more respectable companies.)

One of the reasons these stocks aren't listed on a major exchange is that they are issued by companies with short or erratic histories. Many brokerage houses administer guidelines, called "suitability rules," before they allow clients to invest in OTC or Pink Sheet stocks. Suitability rules typically require the investor to have a certain net worth and a particular level of liquid assets so that s/he will not be irreparably harmed if the investment goes sour.

Another major problem with penny stocks is that reliable information can be difficult to find since they often aren't followed by analysts or scrutinized by the press. Most folks that I encounter daily in our community asking questions about penny stocks are Fools-in-training trying to do their research when there's little or no information to be found.

Perhaps the biggest problem with penny stocks, though, and the one that gets the Securities and Exchange Commission's (SEC) antennae up, is the ease with which they can be hyped and manipulated. In the absence of real information, it's not hard to pick an obscure penny stock, start some kind of believable rumor about it, rope in gullible investors, ride it up a dollar or so, then get out before it collapses, leaving puzzled and disappointed investors holding the bag.

The SEC has charged many individuals and companies with committing fraud over the Internet by hyping penny stocks. One time, the schemers masqueraded as independent securities analysts and promoted the penny stocks in e-mails, newsletters, and on message boards and websites. But they weren't really analysts -- they were simply being paid to promote the penny stocks they were writing about.

They told their readers how great these stocks were, while allegedly neglecting to mention that they were being paid, sometimes in stock, to promote the companies. When their promotion caused the stock prices to spike up, the smarter promoters would try to sell their shares before the stocks came down.

Another well-publicized scam occurred in the case of PairGain Technologies, when an employee posted a message on an Internet message board claiming that PairGain would be acquired by an Israeli firm. The message then provided a link to a completely fabricated "Bloomberg News" website that contained the details of the purported deal. PairGain's stock price increased about 30% in a matter of hours before the hoax was exposed. Ultimately, the individual pled guilty to securities fraud charges.

Not all low-priced stocks are like that, of course, and it has been known to happen with higher-priced stocks as well. In general, though, penny stocks are far more vulnerable to that kind of manipulation since there is a dearth of reliable information to counteract the rumors.

How do Fools protect themselves from these kinds of scams?

  1. Don't invest in penny stocks. If you don't go near the virus, you can't catch the disease.
  2. Don't fall victim to the belief that buying a particular stock right now is a "once-in-a-lifetime opportunity." Investing in penny stocks could indeed be a once-in-a-lifetime opportunity -- to lose your cash. But new and exciting opportunities actually come along all the time; just keep your eyes open and notice them when they do.
  3. Do your research. You shouldn't have to work very hard to find information on a "public" company. But many penny stock companies aren't required to file annual or quarterly reports or audited financial statements with the SEC, and few generate much coverage from the standard financial publications or interest from analysts. Other than the price, the lack of unbiased information about the company is the surest sign that you are dealing with a penny stock. In many cases, the only information one can locate about these companies is on Internet message boards. If you can't find official company information anywhere, take the hint.

Remember, a penny saved is a penny earned. Don't turn an earned penny into a burned penny by risking it on penny stocks.

Related Links:
The Cop Is on the Beat
The Dangers of Bulletin Board Stocks
Notes From the Fringe
A Penny Stock for Your Thoughts
Penny Stock Fraud Uncovered
Buy Zeigletics!

Read More Foolish Four Reports


Top Dow Stocks
( RP Order )

2/8/00

1. Philip Morris
   (NYSE:MO)
2. * Caterpillar
   (NYSE:CAT)
3. * Eastman Kodak
   (NYSE:EK)
4. * SBC Comm.
   (NYSE:SBC)
5. * Int'l Paper
   (NYSE:IP)
6. DuPont
   (NYSE:DD)
7. JP Morgan
   (NYSE:JPM)
8. General Motors
   (NYSE:GM)
9. 3M
   (NYSE:MMM)
10. Exxon Mobil
   (NYSE:XOM)

NOTE: Today's Foolish Four stock selections are marked with an asterisk.

Foolish Four Portfolio

2/8/2000 Closing Numbers
Ticker Company Dly Pr Chg Price
CATCATERPILLAR INC-1/4$41.00
EKEASTMAN KODAK-3/8$61.63
GMGENL MOTORS-15/16$79.50
JPMMORGAN (JP)15/16$119.50

  Day Week Month Year
To Date
Since
12/24/1998
Annualized
Foolish Four -.27% -2.31% -1.85% -3.65% 18.56% 16.29%
S&P 500(DA) 1.32% 1.22% 3.39% -1.87% 17.93% 15.75%
NASDAQ 2.45% 4.32% 12.36% 8.80% 103.79% 87.98%
DJIA (DA) .48% -.06% .16% -4.69% 20.90% 18.32%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
12/24/19989JPM105.514$119.5013.26%
12/27/199918GM73.257$79.508.52%
12/24/199824CAT43.083$41.00-4.84%
12/27/199920EK65.088$61.63-5.32%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
12/24/19989JPM$949.63$1,075.50$125.88
12/27/199918GM$1,318.63$1,431.00$112.38
12/24/199824CAT$1,034.00$984.00($50.00)
12/27/199920EK$1,301.75$1,232.50($69.25)
  Cash: $19.52  
  Total: $4,742.52  

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

Note
The Foolish Four Portfolio was launched on December 24, 1998, with $4,000. Additional cash is never added, all transactions are discussed and explained publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen once per year using a formula based on dividend yield and price. See The Foolish Four Explained for details.