To The Moon

The micro-cap stock market (ie: penny stocks) has a long history of fraud, yet it attracts new investors every day.

The dream of owning the next Microsoft, Yahoo, or eBay at the start-up stage and riding it to easy riches is enough to make even a skeptic’s greed glands salivate.

The other allure of micro-cap stocks is the false feeling of big time investing that comes from buying more shares with less money.

For example, $1,000 will only buy ten shares of a $100 stock, but it will buy 10,000 shares of a 10 cent stock, and 100,000 shares of a penny stock.

Many inexperienced investors prefer 100,000 shares of dubious value over ten shares of real value. They love the idea that a single penny change in the price can double their wealth. Exciting stuff … sort of.

Unfortunately, there are two fundamental problems with penny stocks that make them ripe for securities fraud.

Minimal information: Many micro-cap stocks fall below minimum asset and shareholder requirements for SEC reporting. Lack of information disclosure and regulatory oversight invites fraud because the risk of discovery is lower. Additionally, there’s seldom any legitimate analyst coverage or press scrutiny for many of these stocks, which further reduces information flow and lowers the risk of discovery for scam artists. Con artists will always gravitate where the risk of getting caught is lowest – which includes penny stocks.

Low liquidity: The second problem with penny stocks is low prices, small daily volume, and minimal stock float, making them ripe for unscrupulous promoters to control the stock and artificially manipulate prices. See the example of “Pump and Dump” below for how this manipulation works. In addition, low liquidity can also make selling a large position without negatively impacting price a difficult task when it's time to exit.

The two most common forms of securities fraud in penny stocks are “pump and dump” and “bogus offerings”.

Pump and Dump: This fraud occurs when someone acquires control of a large amount of a company’s stock and then pumps up the price. They then provide misleading and false information in press releases, spam email, internet discussion group postings, and other unverified sources. The sudden burst in promotion temporarily increases demand for the stock, causing the price to rise, which creates additional demand from momentum buyers jumping on the bandwagon, leading to further price increases. Once price momentum is established, the scam artist sells his shares and walks away from the promotion, causing the stock to tank.

Bogus Offerings: This fraud is sold in the form of an unverifiable breakthrough technology or forthcoming large contract announcement for some unknown company. Often, the company will have no operations, earnings, or audited financial statements, and may in fact be little more than an idea or a shell.

The general rule for penny stock investing is to avoid it unless you’re an investor with specialized expertise in the business.

“You may be deceived if you trust too much, but you’ll live in torment if you don’t trust enough.”– Frank Crane

Penny stocks have higher risk for investment fraud than conventional securities, and they require unique investment skills and experience that few investors possess in order to earn reliable profits. They’re best avoided.

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