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Disclaimer: This blog is an expression of my opinion on a particular company or matter. I am not a financial advisor or professional analyst. This is not a solicitation to trade any security. Although I rely on company approved public documents and make all reasonable efforts to confirm the... More
  • Penny stocks or penny slots? 5 comments
    Oct 25, 2009 9:07 PM
    I would like to take the time to release a two-part article for my readers to discuss the potentials profits and pitfalls in penny stocks, and how to invest in them. Readers of my blog who may have watched the stocks I have profiled have had the opportunity to witness the extreme gains and losses that are inherent in penny stock trading. Penny stocks are only for the most aggressive and watchful investors, and should only be a very small part of a portfolio. Traditionalists would advise to avoid them all together, but the profits are too great to resist, and a smart investor can avoid the pitfalls. The recent downturn in the market sell-off of more speculative investments has created many “new” penny stocks out of many good companies This time is a unique time, in that the lack of ability for companies to raise necessary capital has turned many cash poor companies into penny stocks. For example, I will remind readers that earlier this year, Citibank (NYSE:C) was technically a penny stock. In fact, if you look at virtually every penny stock from July 2008 until July 2009 they have nearly identical declines and patterns in price as the major indices have, with the important difference that many of them have not recovered at all like the broader markets have. 
    A stock price recovery for many companies has not occurred because these companies will most likely (statistically) suffer the fate of withering away, and are thus ignored by investors. Yet there are still there are many viable penny stock companies that remain unfairly valued, in my opinion. These companies may be hanging on the results of an important clinical trial, or turning the corner into profitability, or simply under the radar due to exchange de-listing or lack of investor interest. These kinds of extreme small cap value type investments are the ones that I write about and the ones that I feel that penny stock investors may find to be the most rewarding with the least amount of risk. Keep in mind by no means the risk is trivial with these companies, but yet given their low valuation, the risk is worth the reward. That being said: It is a jungle out there. For every good penny stock company there are 100 lousy ones, and many penny stock companies are worthless shells or deliberate scams. So the penny stock investor must be extra astute, and make extra efforts into research to ensure they are not falling victim to investment which had risks they did not understand. 
    Penny stocks are quite popular, with good reason. Many penny stock holders can see regular gains of 50% to 100%, with occasional gains up to even 1000% in a single day. Penny stocks can range in price from one hundredth of a penny (.0001) to one dollar (or more, depending on your perspective). Often it is within an average investors reach to purchase a million shares in a company for $1,000-$10,000. Not only does this number of shares look impressive in your portfolio, it is conducive to dreams about each share reaching one dollar and allowing you an early retirement. But penny stocks have a well deserved reputation for an extreme level of risk, as many penny stock holders have seen losses of 50% to 80% in a day. Penny stocks are extremely susceptible to the influences of traders who can work together, or independently, to drive prices up by buying mass amounts of shares for relatively low amounts of money; or drive prices down by shorting massive amounts of shares. Penny stock traders en masse can drive the price of a stock in either direction at a whim leading to massive gains or losses without warning. There are also many “pump and dump” schemes or outright fraud scams run for the sole purpose of fleecing investors. There are hundreds of zombie ticker symbols that continue to trade on the Pink Sheets that have no company behind them, and are just the defunct shell of a company long since gone or bankrupt. Indeed, “reputable” brokers avoid penny stocks altogether, but there are indeed hundreds of viable, growing companies that are trading as penny stocks. All of these companies are trading for pennies rather than dollars with good reason, but occasionally you can find good SEC reporting companies that are truly undervalued or have unrecognized potential and are indeed the proverbial “diamond in the rough”. With careful action, the average investor can include penny stocks in their portfolio as part of a healthy balance of risk-weighted assets.      
     
    Lesson one: Why is the stock a just a few pennies?
     
                The first thing to consider about a penny stock company is quite basic, and may ironically be the thing investors think about the least: Why are they trading in the pennies (or below)? I will discuss the three primary reasons below:
     
    1)      The company is not viable.
    2)      The shares have been diluted.
    3)      The company is a scam or is cheating shareholders.
     
    The first reason the most common, and can be deduced quickly by examining a company’s history. A company with no cash, no revenue, and no growth potential should be avoided, unless it is developing a new technology. Biotech is a perfect example of this. However, whether or not the technology is viable may take quite a bit of understanding which the average investor lacks. For example, running a car on hydrogen derived from water to increase fuel economy is indeed possible and is an exciting thing to an investor. But only investors who have done significant research into the matter might realize that physics actually prevents the burning of hydrogen from the electrolysis of water to be a net positive energy reaction. Thus, the technology is not viable. This kind of determination is difficult to make, and if you are investing in a technology you do not understand, do so with the understanding that you may lose all of your money because there is a flaw in the technology you didn’t see.
                But the average investor can make fair determinations about if a company seems competently managed and if they have the potential to meet their stated goals.
    Review the company’s stock price history, SEC documents, their press releases, and quarterly statements and you will be able to put together the reasons why the company is trading in the pennies. Often this is simply because, over time, a company was never able to attain profitability and ran out of money. They may not have been able to raise more money to continue on, and with no product or revenue, they sit idle, seemingly caught in “stock purgatory” waiting for something to happen. Other times, a company’s future was dependant on a last-ditch effort for FDA approval, and did not receive it, and with no place to go from there it languishes in oblivion. These companies may continue operations with 1-2 employs, and may or may not ever be able to revive themselves. Eventually these companies will most likely file for bankruptcy, sell off their assets, dissolve the management and disappear.
    In fact, some companies are a few pennies because they are indeed bankrupt. Bankrupt companies should always be avoided- there are very very few examples in all of history where the shares in a company that went bankrupt (“Q” shares) were ever worth anything after a company exits bankruptcy. 99.9% of the time, any equity in the company goes to the creditors, the old shares are wiped away, and new shares are issued- the “Q” shareholders get nothing. Never invest in a bankrupt company, or a seemingly defunct company that does not report to the SEC, update its shareholders with press releases, or at minimum file updates and financial statements with www.pinksheets.com
     
    The second reason for a stock to be trading in the pennies or even sub-pennies is just as common as the first. Rather than give up and close their doors, these companies in “stock purgatory” will often attempt to raise capital for continued efforts to revive themselves. Unable to raise capital through a private equity raise (no investors will take the risk), they utilize a publicly traded companies legal right to issue new shares. They can only do this within the limitations of their capital structure (number of authorized shares), but they can sell these on the open market to the average investor. In this case, the stock trades as if a large holder of stock is always selling- it is hard to see upward momentum this way as there are more sellers than buyers. This has the effect of a slow, downward trend in share price, and may not be obvious in the short term. Traders know how to recognize this using the accumulation indicator. In the long run, this effect can be so dramatic, that stocks trading for $1 can be driven to $.001 with dilution. SEC reporting companies are required to report this regularly, but many companies who do not report to the SEC will often fail to report this all together. 
                Struggling companies often are forced to do this to continue operations. They will issue shares and sell them on the open market to raise money to pay vendors, their own salary, etc. Most companies will never be able to pull themselves out of this downward spiral, but occasionally a company can, and despite the dilution this means wild success for shareholders. But only the most astute investor must invest working against the overwhelming force of dilution. To determine the degree of dilution happening, investors can compare current 10Qs with previous 10Qs to see how many new shares were issued in the last quarter. More proactive investors can call the transfer agent who manages the companies shares. This is usually listed on the company’s website. If the transfer agent will not disclose the amount of outstanding shares (as instructed by the company), contact investor relations at the company and demand a current report. If they do not respond with a share count, stay away: The company is defunct or is intentionally diluting.
    Follow carefully the comparing a company’s outstanding share count and capital structure. For example, if a company has 100 million shares authorized, and 1 million outstanding, they could potentially issue 99 million more shares without changing their capital structure (although having many more authorized than issued shares is quite common and it does not mean they will issue the full amount of shares they are allowed to). On the other hand, if they have 100 million shares authorized and 99 million shares issued, they could only potentially issue 1 million more. However, if they are not an SEC reporting company, they could change their capital structure without warning., For companies who are incorporated in Nevada (as many are due to its lax regulatory rules), you can track changes in capital structure in the state database (https://esos.state.nv.us/SOSServices/AnonymousAccess/CorpSearch/CorpSearch.aspx).
    Also, beware of “dilution traps”. These are legal (and common) ways companies can issue massive amounts of shares. One such common dilution trap is a reverse split. In this case, a company may have 100 million outstanding shares and only 100 million authorized shares; so they cannot issue any more shares. One way around this is to declare a reverse split of 10:1 (1 share for every 10 shares), thereby decreasing the share count from 100 million down to 10 million. This will also have the effect of increasing the share price by the same ratio. So in this example, a 1 cent stock will now become a 10 cent stock.. However, the stock price may then be easily driven back down to a penny by dilutive selling of shares, and you will lose 90% of your investment. Many unreputable companies will perform this over and over again; be sure to look up the company’s history on www.pinksheets.com if they are traded on the OTC.
    Another dilution trap is convertible preferred shares or convertible notes. In this case, outstanding debt or preferred shares is converted into common shares. This dilution can be devastating: If a company’s stock is trading at 10 cents, and they owe one million dollars to their creditors, they could issue 10 million new shares in the conversion. In the case of preferred shares, at the time of the sale the convertible shares have a pre-determined conversion rate. Lets say that a cash-poor company who needs money sells $1 million worth of preferred shares that can convert into common shares. At the time of the sale, the common share price is 10 cents, and the conversion clause states that the preferred shares can convert at this price. This would mean that if all the shares were converted, it would add up to 10 million shares ($1 million divided by 10 cents). Now let’s assume the company has some positive news and the shares in this company go up to $1. At this time, those preferred share holders would be looking at a 1000% percent gain in their investment if they just converted their shares. If they were to do so, the company would have to issue the shares upon conversion and 10 million shares would flood the market, driving down the stock price and changing the calculated market capitalization unfavorably.
                In the third example, where the company is a scam or cheating investors, is far too common these days. It seems that as of late, the SEC has been cracking down hard on penny stock companies who do this, but it still is rampant. How do you recognize a company who is doing this? It is usually obvious- if it is too good to be true it probably is. If a company has no cash in the bank announces it is acquiring a $10 million company, how do you think they could pay for this? If a company has sold  their skin cream product for years, then all of a sudden announces a $100 million military contract to build jet planes, would this make sense? If a company is in the travel business and all of a sudden announces that they have a miracle cure for cancer, how likely is this? Usually in these cases, greed will cloud investors judgment, and people will knowingly buy into the scam hoping for a positive return with stock momentum. But if you choose to stay away from these obvious scams, it may be tough to sit back and watch the share price rise 1000%. But I assure you, when the SEC steps in without warning and halts trading of this companies shares as has happened several times recently, you will be happy you stayed away.
    Keeping these things in mind is important for deciding to invest in a penny stock. 
    Most of the time with penny stocks, you are investing in the future potential of a company, not the current status of a company. Things like revenue, market share, and so on are irrelevant because the do not exist for a developing company. You need to ensure that you have enough information for the critical factors. Here are 10 questions you should find answers to before investing is a speculative penny stock:
     
    1. Has the company stayed focused on their core development goals (positive)? Or has the company dramatically changed business plans (negative)?
    2. What is the likelihood that the technology or product will be successful?
    3. Do they have the knowledge and experience necessary to be successful?
    4. Does the company make any financial information publicly available?
    5. Does the company have sufficient cash to continue with their plan? If not, how will they get it?
    6. Is the company currently massively diluting shares, has in the past, or is likely to in the future?
    7. If the company associated with known stock scams or promoters? Are all of its “partners” companies with no information available?
    8. Is the company’s market cap extremely overvalued (number of shares times price per share)?
    9. Is the stock being massively self-promoted (new PR every week)?
    10. Does the stock have frequent sell offs upon news (key signal for dilution)?
     
    There does not necessarily have to be a satisfactory answer to all of these questions; if there was, the stock would not be trading at an undervalued price. But negative answers to these questions will raise potential red flags. As with all stocks, you should weigh the risk against the reward. You must be realistic about your goals. You need first decide how much money you want to make on your investment in dollar value. For example, you decide you want to make $1000 on a stock. If you feel the stock will double, then you can put $1000 into the stock to meet your goal. If you feel the stock will go up 50%, then you need to put $2000 into the stock to see the same return.  If you feel the stock will give you a 1000% return, you only need to put in only $100. Keep in mind the greater the return, the greater the risk. The other half of this equation is to decide how much money you are willing to lose. If the potential upside is a 100% return, and the potential downside is a 50% loss, your potential risk is 50% of your potential return. If the potential upside is 1000%, and the downside 90%, the risk equals the reward. If you are comfortable with that ratio you can make the investment.
     
    There are indeed many “diamonds in the rough” out there, and a careful analysis will help you decide if you should be involved in the stock or not. But given the volatile price movements in penny stocks, it can be difficult to decide what is a good price to buy, where the stock price is likely to go in the near and distant future, and at what time you should leave with profits or walk away with losses. Formulating an entrance and exit strategy is key to making money in penny stocks and you should have this reasonably well planned out before you own the stock. The next article will discuss these issues.
     
    Next week: Part 2: When to buy, when to hold, and when to sell a penny stock

    Disclaimer: This blog is an expression of my opinion on a particlular company or matter. I am not a financial advisor or professional analyst. This is not a solicitation to trade any security. Although I rely on company approved public documents and make all reasonable efforts to confirm the accuracy of my statements, the comments made in my articles should be considered only as opinion and should not be considered as current or as absolute fact. All investors are strongly encouraged to not rely entirely on any single opinion and perform their own due dilgence when investing. Investing in equities includes considerable risk, and investors should be prepared for the risk of capital loss.
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Comments (5)
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  • Frank the Gerbil
    , contributor
    Comments (6) | Send Message
     
    Being the gerbil that I am, I once swallowed a penny thinking it was a small gerbil cookie. Be that as it may, I enjoyed your article. Kudos to humanoids like yourself that can author something intelligently.
    Frank
    25 Oct 2009, 10:29 PM Reply Like
  • bradenton
    , contributor
    Comment (1) | Send Message
     
    Nice article!!! I've made most of my money on penny stocks since the mid-1990s. Since the early 2000s with precious metal stocks and now Biotech stocks. I have only lost on 2 stocktrades in my life. Currently I hold YMI and CTIC longterm (purchased below .60 cents) and MBST which is about to take off!! I'd advise everyone to get into MBST today!!! Sepsis is one of the biggest medical issues and Medasorb's product is gonna be a HUGE SCORE!!
    Pay attention to floated shares, cash position and product! Also you failed to mention that many stocks such as CTIC are targeted by Hedge Funds who make money shorting stocks (notice paid bashers in chatroom).
    26 Oct 2009, 02:02 AM Reply Like
  • Joseph Krueger
    , contributor
    Comments (283) | Send Message
     
    Author’s reply » Frank, you can run through a maze faster than any gerbil I know, and that makes you one smart rodent. For that, I will follow you!

     

    On Oct 25 10:29 PM Frank the Gerbil wrote:

     

    > Being the gerbil that I am, I once swallowed a penny thinking it
    > was a small gerbil cookie. Be that as it may, I enjoyed your article.
    > Kudos to humanoids like yourself that can author something intelligently.
    >
    > Frank
    26 Oct 2009, 08:26 AM Reply Like
  • Joseph Krueger
    , contributor
    Comments (283) | Send Message
     
    Author’s reply » Without mentioning any stock directly, I agree that penny stocks are especially susceptible to shorting and negative campaigning. As I mentioned, it is relatively easy for a group of traders to move them in either direction (up or down) given their relatively low trading dollar volume. So one has to keep in mind the motives of "pumpers" and "bashers" as they truly can control the price of penny stocks. This is one of the liabilities of trading penny stocks, and I will discuss these types of things in part 2 of this article.

     

    On Oct 26 02:02 AM bradenton wrote:

     

    > Nice article!!! I've made most of my money on penny stocks since
    > the mid-1990s. Since the early 2000s with precious metal stocks and
    > now Biotech stocks. I have only lost on 2 stocktrades in my life.
    > Currently I hold YMI and CTIC longterm (purchased below .60 cents)
    > and MBST which is about to take off!! I'd advise everyone to get
    > into MBST today!!! Sepsis is one of the biggest medical issues and
    > Medasorb's product is gonna be a HUGE SCORE!!
    > Pay attention to floated shares, cash position and product! Also
    > you failed to mention that many stocks such as CTIC are targeted
    > by Hedge Funds who make money shorting stocks (notice paid bashers
    > in chatroom).
    26 Oct 2009, 08:30 AM Reply Like
  • RoyN
    , contributor
    Comments (6) | Send Message
     
    good read, thanks.
    16 Nov 2009, 01:38 AM Reply Like
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