Don't Lose Money Like This

You want to get rich in the stock market by finding that killer stock, don't you? But that desire has meant that some people made millions off of investors like you and me -- millions we didn't have to lose.

The story
On Feb. 23, my colleague Seth Jayson received an email touting the wonders of a tiny company called Recycle Tech. In part, it read:

[Recycle Tech] manufactures and deliveres [sic] premium eco-friendly container homes, as well as LEED Certified Green homes, communities, buildings and city structures across the world. These structures will not only decrease pollution and reduce waste materials, but will also increase the quality of life of millions of poor and homeless people! ... Also imagine the potential uses for these homes for the population of cities needing to evacuate forest fires, floods, or other natural disasters. ... It must be an amazing feeling knowing that you have contributed to the improvement of the world, in some way. ... [Recycle Tech] is definitely a hidden gem at the moment, with a lot going on in terms of growth and expansion.

That day, nearly 18.4 million shares were traded at prices between $0.20 and $0.28 -- up from the 400 shares traded three weeks earlier. Assuming an even flow of shares, $4.4 million changed hands that day.

Today, the shares are priced at just $0.05.

What happened?
It was a classic pump-and-dump scam.

A message hyping the future prospects of a really, really tiny company goes out to investors who get excited about the prospect of striking it rich. The investors jump in and buy tons of shares of the company, usually from insiders, and often from the very people sending the email.

They get cold, hard cash. The investors get shares that quickly drop back down to their true worth.

But if the people buying those shares had done just a little bit of digging, they would have seen the warning signs:

• Recycle Tech had no revenue for the previous 18 months, while refurbishing and selling used computers.
• It had $81 cash in the bank at the end of November.
• On Jan. 27, it sold itself to Belmont Partners, which then sold a major stake to Green Building & Engineering Contractors just one week before that email was sent.

Not a great investment, in other words.

The honest truth
Why do penny stock scams work? Maybe it's the lure of owning thousands upon thousands of shares. Maybe it's the thought that shares only have to rise by a few pennies to double, and how difficult can that be?

But these scams don't make the average investor rich. Instead, people who make real fortunes in the stock market invest in a different class of company altogether: small-cap stocks.

In a way, small-cap stocks work on the same principle as penny stocks. Their small base makes it much more likely that real growth can happen, but they also have what Recycle Tech does not: revenue, little debt, real products, and real growth prospects.

Take a look at these former small caps:

Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months. All dollar amounts in millions, as of 15 years ago.

Each of the above sold (and still sell) real products or provided a real service, had real revenue, and was not heavily in debt. And as they grew successfully over the years, their stock prices rose, reflecting that success. But they aren't small caps now.

While these may still be good companies, they aren't likely to provide the same returns going forward as they did in their early days.

A few ideas for your portfolio
Today, looking for small companies with real revenue and operating earnings, as well as net cash positions, is a good place to begin. Here are four possibilities:

Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months. All dollar amounts in millions.

Of course, there's more to it than just looking at a few metrics. Success in small-cap investing also means looking for companies that have rising demand, relatively few analysts following them, and management that owns a significant stake.

Under Armour, for example, has seen revenue grow by an average of 24% over the past three years. JA Solar has seen three times that growth rate, as demand for its products increases. The three cofounders of STEC own 20% of the company, so their interests are aligned with ours. And Hecla has just eight analysts tracking the company, compared to 27 scrutinizing competitor Barrick Gold.

These are the kinds of companies Motley Fool Hidden Gems co-advisors Seth Jayson and Andy Cross look for -- small companies selling real products with the potential for growth. If you'd like to see what they're recommending today, take a free, 30-day trial by clicking here.

Jim Mueller does not own shares of any company mentioned. Under Armour is a Motley Fool Hidden Gems and a Rule Breakers recommendation. The Fool owns shares of Under Armour.The Fool's disclosure policy likes a good penny stock joke, but is completely above board.