By MARY LYNNE DAHL, CFP®
March 13, 2017
One reason penny stocks are so risky is that as very small companies that have minimal or no capital, they are easy to manipulate. They have no track record, no earnings, little or no assets and often no prospects for earnings in the future. With no earnings and little or no assets, penny stocks do not have much of a market, making them very illiquid in many cases. If no one is buying or selling shares, an investor who wants to sell shares has no one to buy them. Illiquidity is a serious risk and common with penny stocks. In addition, all of the data about them is unproven and sometimes false. Investing in them is simply gambling.
The high-risk, speculative nature of a penny stock company makes it a target for all kinds of fraud. One is a scheme called "pump and dump", in which the company uses a variety of ways to artificially inflate the value of the stock, then sell it to investors who overpay for it (because it is cheap) and end up losing their money when it drops back down to a more realistic value, often zero.
The ways these manipulators pump up the value are clever and varied, often with web chat rooms full of fake stories about how great this stock is or will be, or with a massive direct mail and advertising campaign aimed at hyping the company. Sometimes the value is falsely pumped up by people who pose as investors or "insiders", people who are on the inside of the company and therefore know things not available to the general public. These insiders circulate around in communities, making public comments and on web sites and in fake press releases that make it appear that the company is going to break through some barrier to profitability and soar upwards in value, soon. Often, these "stories" gain momentum when new investors jump in, buy shares and start talking to friends and family about how they plan to make a killing in this penny stock of this particular company.
All stocks are sold under specific regulations overseen by state regulators and by the SEC, the federal regulators. There are rules for every kind of stock that is offered to the public and companies must qualify for listing on the major stock market exchanges before their shares can be traded. However, penny stocks do not qualify for listing on the major exchanges and have fewer requirements for being traded. As a result, many penny stocks fail to provide financial disclosures, often have unaudited financial statements or no financial statements at all and often show no earnings, sometimes even showing negative earnings. This means that they somehow have spent more money than they have on hand. Because a company cannot sustain itself this way, penny stock companies often fail, with investors losing all of their invested dollars.
The kinds of companies whose shares are so cheap that they are classified as penny stocks are often very small energy, mining, tech and biotech companies. It is common for them to be involved in some new "breakthrough" technology that they predict will change the future for the world, something so innovative and radical that once it is on the market, the company will soar to new heights and the stock will become very valuable. Once in a while a truly innovative idea does happen, as a start-up in a garage somewhere. This however, is the very rare exception. More often, today's innovations are being made in university and corporate laboratories, research departments and tech fields, financed by major companies standing ready to produce the next generation of products using the brilliant ideas and innovations of creative minds at work. Major discoveries are almost always patented, sold to large firms for production and application, not kept in small companies struggling to raise capital and stay in business.
When you do hear of a small company that seems to be on the verge of some huge breakthrough that will be the next big thing, ask yourself why the company has not attracted the attention and financial support of a larger company in a related field. Think about this; if the product or service is so innovative, important or crucial to a specific application that is in demand today, why is this company still struggling to raise capital? If the capital raised by investors who buy the penny stock is simply being used to pay the salaries, bonuses, perks and travel expenses for the men and women who run the company and sell the penny stock, it is worthless as an investment. If the capital is not being used to develop a product or service that can be marketed profitably, this is a problem if you are an investor supplying the capital for this company. Too often, investors in penny stocks are told that the breakthrough is right around the corner, but that breakthrough keeps being delayed and often, it never happens. Somebody is, indeed, making money here but guess what; it is not the investors.
State and federal regulators periodically publish warnings to the public about investing in penny stocks. Nevertheless, some people disregard those warnings, seek out penny stocks and invest. There are blogs, chat rooms, specialist brokers and web sites for almost every kind of penny stock and every kind of strategy for picking "winners". The greed factor is working hard to separate investors from their hard earned money by offering all kinds of get-rich-quick schemes using penny stocks as investments. If you read this column often, you already know what I think about getting rich quick. Real investors get rich slowly, not overnight. Real investors have a plan, not a scheme. Real investors use discipline, not greed, to guide them to good investments. Although I am sure that there have been and may be a few penny stocks in the future that are worth investing in, they are few and far between. As a category of investment, know the risks and remember that you have been warned.
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©2017 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2017
Mary Lynn Dahl can be reached at firstname.lastname@example.org
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