MoneyMorning.com Report - A few years back I got asked what, if
anything, I like about
during a standing room only presentation at an investing conference
"You mean aside from the fact that most have no proven track
record, little or no assets, hardly any operations history, low
prices that make them ripe for manipulation, and products that
haven't been tested in the market place?" I quipped with a
My audience chuckled nervously, not sure at first where I was
going with my answer;
are very popular, and the dream of finding the next great
Microsoft, Facebook, or Netflix is alive and well in the minds of
But, then, they relaxed when I explained that finding successful
penny stock investments
is no different than finding other great investing opportunities...
if you know what to look for and have the right risk tolerance and
That's what we're going to talk about today for the simple
reason that tiny micro-cap companies - penny stocks by any other
name - can be fabulously profitable over time when done right.
And that, of course, is the allure.
Here's what to look for when trying to find the most promising
Penny Stocks' Potential for Fraud Is Written into SEC
First a little background.
The U.S. Securities and Exchange Commission generally
categorizes penny stocks as the shares of any company trading at
$5/share or under and having a capitalization anywhere from $50
million to $300 million. Sometimes the cut is $1 to $3 a share,
depending on the definition.
Typically, most of these companies have such small market
capitalizations that they don't meet the standards needed to trade
on major exchanges like the New York Stock Exchange or Nasdaq, for
example. Most are, as a result, traded in so-called
"over-the-counter" exchanges (OTC), meaning the stock is sold by
and to individuals connected by phone or computer networks.
If you've ever heard the expression "pink sheets," this is
sometimes used interchangeably. Over-the-counter trades - OTC for
short - used to be written on pink sheets of paper.
Here's where it gets tricky.
It's tough enough to find accurate information about bigger,
more established companies when it comes to investing. But it's a
whole lot more problematic for small caps.
That's because OTC companies don't have to meet the same
SEC-mandated financial reporting standards as their larger, more
established peers. The requirements for timely reporting, among
other things, leaves a lot to be desired. So do auditing
Not surprisingly, this makes OTC stocks an attractive vehicle
for fraudsters, who will often breathlessly lobby unsuspecting
investors over the phone, spinning a narrative of a tiny company
that's poised for tremendous upside. Pump-and-dump scammers don't
help because of their false and misleading actions.
That's where many investors get into trouble.
They figure the potential for higher rewards makes the exposure
worth it, so they pile into penny stocks without much thought.
After all, they reason, if a stock is trading at $0.10/share, it
just requires a small push to bump it up to $0.15/share - a rapid
What they're missing is that the same penny stock can just as
easily move in the wrong direction, trading at $0.10/share the day
they buy it and $0.05 the next. And the 50% loss is even worse than
it appears, because penny stocks tend to have far less liquidity
than their bigger brothers. So price moves can be far more rapid
and jagged than many people expect.
There are ways around this, though, and we talk about those all
the time, including the need for specific company research, p
(the tactic of only allocating a small percentage of your
capital to any investment, to reduce the chance of a catastrophic
loss), and dollar-cost averaging, among other things.
But most of the time, you're better off simply not taking the
risk in the first place.
How do you know which companies are "worth it"?
Fortunately, the answer is not as difficult as you might
Penny Stock Red Flag No. 1: Management Doesn't Seem Invested in
I've analyzed thousands of companies during the course of my
career, and it's not always obvious which ones have the best
potential. That's why I recommend you take a detailed look at a
company's 10-K as part of your pre-investment research.
If you've never heard the term before, a 10-K is a periodic
report mandated by the SEC that details a company's financial
performance. Like most government-required paperwork, reading one
of these things is about as exciting as watching paint dry. There's
a specific format and an even more specific list of things a
company has to include when it files.
Every 10-K report, for example, contains detailed information on
a company's history, equity, shares outstanding, holdings, and
subsidiaries - all in appallingly bland detail. A 10-K,
incidentally, is different from an "annual report to shareholders,"
which is frequently all dolled up to present the most favorable
spin on their prospects.
I frequently start with executive compensation.
It's normal these days for CEOs to be paid at least partly in
cash, even with small companies, as almost everyone can be expected
to face liquidity events over time. But when an executive pays
himself exclusively in cash, with no thought for deferred
compensation, a red flag goes up.
Successful small-cap stocks are aligned top to bottom, meaning
that management and shareholders both have a vested interest in
success. Hopefully the
A small-cap exec with an all-cash compensation package and no
options or vesting tells me that there's very little alignment.
Worse, it suggests management has no faith in the company's
long-term outlook and is using the corporate treasury as a slush
fund to maximize his or her earnings even if the company goes up in
For example, I recently examined a small-cap company with what
sounds like a promising clean energy technology. The 10-K revealed
that the CEO of the company in question was paying himself nearly
$2 million a year in cash and bonuses with no stock options or
At the same time, though, the 10-K also revealed that the
company has accumulated debt of more than $200 million and
liabilities that outweigh cash and other assets by 7 to 1.
My experience suggests that there's a direct correlation between
CEO pay and performance - the more they get, the worse their
And I'm not alone.
A 2014 study by Michael Cooper of the University of
Utah, Huseyin Gulen of Purdue University, and P. Raghavendra Rau
confirms that there is a direct relationship between what CEOs are
paid and the next three years of performance. According to the
authors, the returns of higher-paying firms are almost three times
than low-paying firms.
If a CEO isn't betting on shares of his or her company rising,
there's no reason you should.
Penny Stock Red Flag No. 2: Weak Statement of Operations
Penny stock companies can be unprofitable for long periods of
time, yet still have an exceptionally bright future.
Here, too, the 10-K can be very helpful because it shows not
only a company's condition at a specific point in time, but over
time. And that, in turn, will tell you whether the company is
moving in a direction that's consistent with its stated goals.
For example, I've recommended
Ekso Bionics Holdings Inc.
) as one of the most inspirational small-cap stocks I've seen in
years. The company trades at only around $1.15 a share now, but I
think it could hit $21.84 a few years from now, assuming management
continues to charge down the path they've chosen.
The company's most recent 10-K report, filed in March 2015,
shows that the company has spent heavily on medical and engineering
devices, which is exactly what you would expect for a company
that's growing sales and landing new medical and engineering
contracts for its products.
Further, the $3.86 million spent on research and development (up
sharply from the $2.67 million spent the previous year) shows the
company is serious about not just protecting but expanding its
In other words, the company's spending is absolutely consistent
with its objectives.
On the other hand, I reviewed a bio-fertilizer company in China
a few years back that had fabulous plans to manufacture and
distribute a breakthrough crop yield enhancer. Given the terrible
shape of most of China's agricultural land, this made a lot of
sense - right up until I saw plans for an amusement park and hotel
posted on the back of a greenhouse in their research acreage.
Turns out money being invested in "research" was being diverted
into other assets that were not consistent with the core product
lines or even a logical extension of the business. And that was
reflected in the 10-K, with a surge in assets and expenses falling
outside the primary business.
Penny Stock Red Flag No. 3: Paid Promotions
Promoters and unscrupulous corporate insiders are often in
cahoots when it comes to penny stocks. Not that you'd know it from
the glossy spreads you and I both get in our mailbox from time to
The slick story and well-written copy are designed to make you
think the company being promoted is truly transformative, with
potential profits that could transform your own life. Supposedly
independent, it's actually paid.
Many times analysts take large cash payments in return for
providing glowing coverage, or they receive shares that they can
quickly unload after they trigger their intended buying spree.
Consider the following example I've pulled from our files at
The thinly camouflaged disclaimer reveals that the research company
doing the paid promotion received 550 restricted shares from the
company and will receive 550,000 shares during the course of
conducting their research. Shares that, I might add, they're
telling you they will sell at any time and without warning...
probably as unsuspecting buyers are being lured in.
For a long time Wall Street itself was no better. In many ways
it still isn't.
Commissions and trading used to be the economic rationale for
traditional research offerings. In-house analysts made "calls" that
caused people to buy or sell securities in almost reflexive
fashion, which was great when the markets were headed higher. Some
analysts achieved almost rock-star like status even as their work
supported commissions. Others like Henry Bloget and Mary Meeker
were vilified when dot-com became dot-bomb.
Yet, the practice still continues today as part of almost every
Private Placement leading to an initial public offering. Rather
than face regulatory pressure in today's litigious environment,
Goldman Sachs, for example, puts a disclaimer in its documents
telling clients that the firm could short the very shares clients
are buying or dump shares of a given transaction at any time.
Effectively, Goldman and other firms have rigged the game so
that insider trading is not only totally in the open, but brazenly
in your face and perfectly legal.
When I started
, I insisted that none of our writers - including me - receives any
sort of compensation whatsoever for recommending a company. Either
a company we're recommending stands on its own merits or it
My goal, as always, is to eliminate the inherent conflict of
interest that traditional research represents. At the same time, I
want to educate you so that you know how and why my team and I form
the opinions I share with you here in
and in our sister publications.
Speaking of which, let me leave you with one last point.
If you're going to invest in a penny stocks from time to time -
and I hope you do because they can be a great complement to a
disciplined investment strategy - make sure you keep the risks in
I'd love to be able to tell you that every recommendation I have
will be a winner, but that's just not possible - not with large
caps and certainly not with penny stocks. Even I'm going to hit a
stinker from time to time. Every investor will sooner or later if
you're in the markets long enough.
But that's why you want to really bone up on your risk
Winning, in many cases, is about not losing in the first
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For investors who want to complement their portfolio with
penny stocks, Keith believes Ekso Bionics Holdings Inc. (
) still has plenty of room to run, even after outperforming the
markets in the 14 months since he recommended it to
subscribers. For the full, updated report on the enormous profit
potential Keith has uncovered, sign up for
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