Three Red Flags for Penny Stock Investors

A few years back I got asked what, if anything, I like about penny stocks during a standing room only presentation at an investing conference in Florida.

"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 smile.

My audience chuckled nervously, not sure at first where I was going with my answer; penny stocks are very popular, and the dream of finding the next great Microsoft, Facebook, or Netflix is alive and well in the minds of millions.

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 perspective.

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.

Penny Stocks' Potential for Fraud Is Written into SEC Regulations

penny stockFirst 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 stipulations.

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 50% gain!

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, position sizing (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 imagine...

Penny Stock Red Flag No. 1: Management Doesn't Seem Invested in the Company

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 same interest.

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 flames.

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 additional vesting.

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 companies do.

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 lower 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. (OTCBB: EKSO) 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 technological edge.

In other words, the company's spending is absolutely consistent with its objectives.

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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 time.

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 random.

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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.

And us?

When I started Total Wealth, 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 doesn't.

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 Total Wealth 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 perspective.

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 management tactics.

Winning, in many cases, is about not losing in the first place.

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Editor's Note: For investors who want to complement their portfolio with penny stocks, Keith believes Ekso Bionics Holdings Inc. (OTCBB: EKSO) still has plenty of room to run, even after outperforming the markets in the 14 months since he recommended it to Total Wealth subscribers. For the full, updated report on the enormous profit potential Keith has uncovered, sign up for Total Wealth here - it's free!

About the Author

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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