The majority of investors are always looking to make a massive profit. In many cases, investors will do almost anything to make a quick buck. Although, some may have made large profits through conventional investment strategies such as purchasing mutual funds or large cap stocks, there are always investors who go another route. This is when they enter the realm of high-risk penny stocks.
Why are penny stocks so attractive to investors? The main reason is because of their low price. Most penny stocks can range from a few cents to about $2 a share. The majority of penny stocks are priced like this due the overall size of the company. Furthermore, this is an easy way to accumulate gargantuan amounts of shares of a company's stock.
Many proponents of purchasing these micro-cap equities attempt to convince the general public that owning a few shares of a blue chip stock will never make you any money. In reality, most of these micro-cap equities never make investors a profit. Blue chip stocks are labeled that for a reason. These companies have proven to the public that they are large enough to not just pay stable dividends to shareholders, but consistently create shareholder value over time.Credit: Wikimedia Commons
Another interesting fact about blue chip stocks are their fundamentals. Typically, their fundamentals are fantastic. Usually their earnings, revenue, operating margin and cash flow not only are positive, but they tend to increase over a given period of time. Now, what are the fundamentals of most penny stocks? You can probably figure that out by now. In addition, that is if the company which is traded as a penny stock even has any operations (some may have partial operations, but most of them do not have any at all).
If you take the time to research enough micro-cap equities, you will find that the majority of the outstanding shares of these companies are almost always solely owned by the top management. This means if a company has 50 million outstanding shares, the management probably owns about 75% to 85% of the shares. This is not only dangerous for the shareholder, but it leaves investors vulnerable to “pump and dump scams”. Moreover, investors usually will see massive swings in the share price, but never receive any public information on what is actually moving the stock price. This tends to be when management moves around shares.
In recent years there has been a bunch of scams related to Eastern European/Russian hackers. The strategy combines a mixture of computer hacking and identity theft to rip-off innocent investors. These criminals successfully attempted to break into people's accounts and purchases large numbers of micro-cap equities.
According to an SEC complaint, innocent victims claimed that hundreds of thousands of shares were purchased from their brokerage accounts. The companies that were purchased were penny stocks that traded under 25 cents a share.
In many cases these criminals were the ones who also owned these penny stocks and sold off the shares when they hit an all time high (Ultimately, contributing to a “pump and dump scam”). This scam is officially called the “hack, pump and dump”. The SEC is aware of these scams and always warning investors (especially if they already own micro-cap equities or are thinking about purchasing them) to be extremely careful.
The exploding Chinese economy has attracted a lot of investors over the years and the micro-cap sector is especially popular. Unfortunately, scams related to Chinese micro-cap equities are also on the rise. Over the past several years, dozens of Chinese micro-cap equities were delisted from exchanges due to suspicious and fraudulent activity.Credit: Wikimedia Commons
The technique that is used is called the “reverse merger”. The way the scam works involves a Chinese based-company purchasing an American-based company which already trades on a U.S. exchange. In the end, it allows the Chinese company to trade in the U.S. without going through regulatory review. Since Chinese-based companies have lenient regulatory and accounting laws, these Chinese-based companies can now easily falsify earnings and rip-off honest Americans.
Investors have lost millions due to these scams and many people believed that these companies were going to make them rich in virtually no time. Instead, their experience with Chinese stocks have been a nightmare. Now don't get me wrong, there are some legitimate Chinese-based companies out there, but it is getting more difficult to find the ones that play by the rules.
Lastly, there are so many promotions that want to convince you that micro-cap equities are the way to go. The majority of them are sent via email and attempt to convince you that you would be crazy not to own them. Many of these supposed "newsletters" are actually paid penny stock promoters. These can lead to almost any scam that we spoke about before. Typically, they will also include fake testimonials to lure you into the idea that people actually followed them and became wealthy. Yes, that is true that a testimonial here and there may be true, but most are not.
Penny stocks have been around for decades and as long as they exist, the immense amount of risk that comes with them will always be there. Today, they are more dangerous than ever were due to the massive expansion of the internet. Back in the day, penny stocks were still considered dangerous, but now the risk involved is unprecedented.
Today, many individuals in the financial industry and/or individual traders will still attempt to convince people that penny stocks are magnificent investments. There are even books written on them. Most successful investors have never purchased penny stocks and never will, and this is because the majority of larger, more stable companies are just better investments over the long term. Penny stock investors/traders purchase these stocks hoping to become “penny stock millionaires” overnight and usually never do. If they ever did become “penny stock millionaires” it was probably pure luck, the same way a person wins the lottery.Credit: Wikimedia Commons
Besides, if they knew which penny stocks would become the next big company to join the New York Stock Exchange, would they really be sitting home on their computer trading more of these stocks or would they be working at a major Wall Street firm? In fact, if they really knew which micro-cap stocks were going to become the next big company they probably would be working for Warren Buffet and buying every company that exists on the over the counter exchange (Then again, that is if the company has an actual 10-K filing that is accurate. Oh yeah, and if the company has a product or service that actually exists).