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Published: November 5, 2009
There’s no question about it -- penny
stocks can bring home some of the biggest gains in the
investment world. But those tiny companies can also bring along
quite a bit of risk. In fact, one of the biggest questions we
get here at Penny Sleuth HQ is: “Can you tell me if
XYZ Corp. is legit?” And while we can’t give out
personalized investment advice, we can give you the tools to
determine whether you’re investing in a business with serious
profit potential or a scamster’s shell game...
Here’s how to know if your next penny stock play is legit...
For many investors, the idea that a stock could be representing
itself incorrectly is unthinkable. After all, we’ve got the SEC,
the exchanges -- like NYSE and NASDAQ -- and independent
auditors taking a look at every filing that a company puts out
to shareholders. But in the world of microcap stocks, many of
those same protections just aren’t there.
While Securities and Exchange Commission (SEC) was created, in
part, to protect investors from nefarious activities in the
stock market, the countless securities scandals of the last
couple of years have shown us that the agency simply doesn’t
have the resources to make sure that the smallest companies are
reporting accurately. And in fact, many of the smallest microcap
stocks are completely exempt from reporting to the SEC.
Serious listing requirements (almost always) ensure that stocks
trading on major exchanges are legitimate businesses, but for
stocks that trade OTC or on the Pink Sheets, the requirements to
get shares trading are slim to none.
And while most investors think of audited financials as a
safeguard that keeps a company’s financials accurate, many
companies also aren’t required to get their books audited
because of their size.
Even if you’re thinking about investing in a Pink Sheets stock
that’s exempt from registering with the SEC and getting an audit
performed, you might still be looking at a perfectly good penny
stock investment... but you have to do your homework.
Verify the Business
The first step to determining whether a penny stock is
legitimate is to verify that the business exists and does what
you think it does.
You can start off by entering the stock’s ticker on a major
financial site -- like Google Finance -- and checking out the
description of the company. Those descriptions come from SEC
filings, so you can generally trust what they say since thanks
to the Sarbanes-Oxley Act, it’s a felony for management to lie
on company filings.
Also, log onto the SEC’s website and look for company filings to
get the full look at a company’s operations. And don’t forget to
look at its ticker... an “E” at the end means that the company
is delinquent in providing its regulatory filings -- a very big
red flag.
For companies small enough to not file with the SEC, ask your
broker for a copy of the company’s “Rule 15c2-11 file.” In it,
you’ll find a slew of information that the company was required
to provide to prove their exempt status.
Check the Auditor
When you’re reading a company’s financials on the
SEC website, look for
the audit opinion (generally near the end of a 10-K annual
report filing). It’s a statement from the independent auditors
that explains the steps an auditor took to verify a company’s
financials as well as whether the financials are accurate in
their opinion.
Checking who the auditor is makes a big difference too. Bernie
Madoff’s “independent” auditor was neither -- he trusted Madoff
too, blindly signing off on the scamster’s financials and losing
millions of his own in the process. Checking into the
accountant’s CPA firm would have showed that it was a tiny
storefront with only one CPA and without the manpower to audit a
multi-billion dollar financial firm.
Getting audited by one of the “big four” accounting firms --
PricewaterhouseCoopers, Deloitte, KPMG, and Ernst & Young -- is
generally the domain of big blue chips that can afford to have
prestigious accounting firms handle the audit, so don’t stress
if the auditor’s name doesn’t look familiar. Take the time to
research who the auditor is, though, and whether they’re
qualified to handle a company audit. A quick Google search
should solve that...
Give Them a Call
Hard-to-find contact information is another red flag that should
be watched out for. Since most companies are constantly on the
lookout for new business, their sales team should at least be
easily accessible. If you have concerns about whether or not the
company is legit, go ahead and call the phone number on their
website. If you can’t find a number or address, check back on
the SEC website -- companies have to include their corporate
contact information on the cover of all 10-K and 10-Q filings.
New technology has also made it much easier to verify a
business’s contact information. Just type in a company’s address
into
Google Maps, and
select “Street View”, and you can actually see the building
where its offices are located. If the offices for a publicly
traded stock are showing up as someone’s home or a mailbox
rental store, be very wary of going forward.
Follow the Money
If you really want to know about a company, you have to follow
the money -- its customers...
For any company that markets its products to consumers, a quick
web search should give you an idea of how well -- or poorly --
the company is treating the people who use its services. Reading
customer experiences will also give you an idea of whether or
not people are jibing with the company’s offerings.
Googling your way to customer experiences isn’t always an
option, especially when a company caters to enterprise or
government clients. In these cases, where more money is
generally involved, lawsuits are more likely as a result of
business disputes. Check an online legal database -- like the
U.S. PACER System --
to see whether your potential microcap investment is being sued
by customers.
Check for Promotions
It’s possible for a company to be legitimate while the news that
“independent parties” are touting isn’t. These so called “stock
promoters” are publishing faux research reports and stock
recommendations in hopes that investors will catch on to the
penny stocks they’re selling. They do this through websites and
newsletters that seem legitimate on the surface, but are
essentially nothing more than schemes to get people to buy these
stocks.
While we’ve never accepted money to write about any stock here
at the Sleuth, some in the industry do... And believe it
or not, it’s completely legal as far as the SEC is concerned.
There are a few ways that you can tell whether a stock’s being
pumped by a promoter. For starters, go to the horse’s mouth --
check out
StockPromoters.com -- the site features a listing of
which stocks are paying for which promoters, as well as what the
promoters are getting in return.
Promoters aren’t ashamed about what they do -- they want
companies to know how good they are at their jobs... that’s why
they’re so easy to spot.
More Homework, More Profits
To be sure, doing the research is tough and time consuming. But
it’s also the only way to be completely sure that the next penny
stock play you’re putting your hard earned money on the line for
is legit. Small stocks have some of the greatest gain potential
out there -- and if you know what to look for, you can make sure
that you don’t get burned in the process of pursuing profits.
-- Jonas Elmerraji
Contributing Editor
Penny
Sleuth
Editor's Note: This
article originally appeared in
Penny Sleuth. |
