Lessons From Pennies

Motley Fool Staff
Motley Fool Staff
Apr 2, 2003 at 12:00AM
Other

You read it here first: Jack's Asparagus Soda tastes good, doesn't smell bad, and can make you rich!

Well, not really. It's April 2, the day after the Fool national holiday, and the punch line is out -- we're not actually introducing a new penny stock newsletter called The Motley Fool's Penny Pal.

Did we get ya? Did you try to pick up a few thousand shares of PapuaLodge with your spare pocket change?

The reality is that our ridiculous penny-stock product -- the bald-faced hype, the over-zealous punctuation, and the empty promise that penny stocks are your sure path to riches -- is not so different from "products" promoted out there on the Wild, Wild Web. In fact, one of our "buy reports" is based heavily on an email received by writer Bill Mann, featuring the subject line "3 Cent Stock Could Be Worth $1."

Bet you've gotten a few of those in your inbox, eh? Heck, even if you caught onto our ruse from the outset, the feverish pitch of our daylong trading report has scary roots in reality. Maybe that's what makes it so easy to spoof.

Penny-stock hype is hardly a new phenomenon. Since it's our day to fess up, we'll let you in on another little secret: The penny stock joke is one of our old favorites. Back in 1994, The Motley Fool created Zeigletics, a penny stock that was purportedly traded on the Halifax Exchange. Even though the company, its product, and the exchange were complete fabrications, financial message boards on America Online(NYSE: AOL) and Prodigy were filled with lively discussions about the company. People actually tried to purchase Zeigletics stock based solely on what they read on the message boards.

What's so wrong with penny stocks?
First, let's be clear with what we mean by a penny stock. Here's what the Securities and Exchange Commission (SEC) has to say: "The term 'penny stock' generally refers to low-priced (below $5), speculative securities of very small companies. All penny stocks trade in the OTC Bulletin Board or the Pink Sheets -- but not on national exchanges, such as the New York Stock Exchange or the Nasdaq Stock Market."

While most people agree with the $5-per-share denotation, we don't necessarily agree that an ultra-low-priced stock's listing on a major exchange makes it safe -- just a little less speculative. In fact, some of the come-ons we modeled our buy reports after promoted companies listed on one of the major exchanges.


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Perhaps it's better to think of these as "penny companies." After all, shares of Lucent(NYSE: LU) are trading at around $1.50 -- but the company is worth almost $6 billion. This is not a stock that could be easily manipulated. Thus, we often add the criterion that a company's market cap should be around $100 million or less to qualify as a true penny stock.

What's so risky about investing in penny stocks? Just the following:

As liquid as mud: In a single day, millions of shares of the stocks in the Standard & Poor's 500 change hands. However, when it comes to penny stocks, just a few thousand trade in a day, and sometimes none at all. Even for those rare issues that see trade numbers in the millions, the dollar amount traded is still low. One hundred thousand shares of a stock trading at a nickel a share is still only $5,000. This illiquidity makes penny stocks more susceptible to manipulation. Also, such low trading volume keeps mutual funds and other institutional investors away since relatively small investments can artificially drive up or down the stock price.

No information: Along with the lack of institutional interest comes the lack of analyst or media coverage. There are very few ways to confirm the claims of a company residing in penny-stock land. Furthermore, many penny stocks are not required to file financial reports with the Securities and Exchange Commission, so it's difficult to get a look at the company's numbers.

They're cheap for a reason: Penny stocks, on the whole, don't have an impressive record. One study showed that 75% of stocks trading below $5 were bankrupt 10 years later. Another study released by Merrill Lynch in 2001 found that, going back to 1987, of 1,900 technology stocks that were trading below $10 a share, only 3.4% rebounded to above $15 in one year. Of course, a 50% return is a lot to ask in a year -- but isn't that the kind of return those penny-stock newsletters tout?

Fertile for fraud: With such little public information available and such little trading activity, penny stocks are enticing prey for ne'er-do-wells. The most popular scam: the pump and dump. No, that's not some new dance craze -- it's an illegal activity whereby someone buys a block of penny stocks, "pumps" up the price by disseminating overly optimistic information about the company (through email or Internet discussion boards), and then "dumps" the stock (i.e., sells it) once the price has risen sufficiently. Thus, he's made his profit before the information is found to be false and the stock price plummets.

These scams range from the complex to the comical. Edward A. Durante and a host of other conspirators used brokerage accounts opened by offshore entities (with such legitimate-sounding names as Berkshire Capital Partners and Prudential Overseas Company) to artificially inflate the prices of several penny stocks.

And then there's the case of then-14-year-old Jonathan Lebed, who settled with the SEC by paying a fine of $285,000 but neither admitting nor denying that he pulled a classic pump-and-dump. He allegedly would buy a large block of penny stocks, promote them by posting false or misleading information on message boards, and then sell the stocks within 24 hours after the price had gone up. He even placed sell limit orders the same day he bought a stock so he wouldn't miss the run-up while he was in school.

Unfortunately, the market for these stinkers is getting more sophisticated all the time. In 2000, we wrote a series on securities fraud, and things aren't any better. But people still fall prey to the promise of quick, easy, near-instant fortunes.

What's the antidote?
When considering an investment, "think about where it trades," says Gerri Walsh, deputy director of the SEC's Office of Investor Education and Assistance. Stocks that trade on the major exchanges must meet listing standards and file reports with the SEC, available online in the EDGAR database.

When it comes to stocks listed in the pink sheets, keep your spare change in your pocket, Fool. And follow these tips:

  • Look for high-quality companies that are listed on the major exchanges and have market caps above $250 million.

  • Don't believe the hype. Even ours. Never invest based solely on what you read on a discussion board, in a chat room, or in a newsletter.

  • Dig into a company's financials. Understand the numbers -- and that you need to do some homework to really know what you're buying.

  • Before you subscribe to an investment newsletter, find out if the newsletter is being compensated for mentioning a company. Check with the SEC, your state securities regulator, and the National Association of Securities Dealers (NASD) to see if the newsletter has ever been in trouble.

If you feel cheated by not being able to subscribe to The Motley Fool's Penny Pal, don't worry. We can still offer you The Motley Fool Stock Advisor and The Motley Fool Select, real-life newsletters with analysis based on solid homework, not on wrestlers named The Regurgitator.

And for more Foolish fun, check out our April Fools' jokes of yore: