You’re out for dinner in your favorite restaurant. The waiter hands you a menu and you immediately focus in on the salad column looking for a healthy meal. Hmmm….broiled salmon on the house salad….looks good. As you continue to study your choices you notice the young couple sitting at the table to your right. Piled in front of him is a creation that appears to be a burger super-duper deluxe. You make the assumption that the burger itself is somewhere north of the conglomeration of French fries and east of the mountain of onion rings. Yes, you think to yourself, that’s probably where it is. Your eyes now wander to the girlfriend sitting across from the hidden burger. Evidently she didn’t want to order a full meal… perhaps it was a first date. Instead she opted for the brownie supreme drizzled in strawberry sauce topped with a mountain of whipped cream. Most of her dessert was on her plate but some of it was projecting from her chin anticipating a soft landing on her freshly pressed jeans. “This must be heaven”, her expression suggested.
You now re-think the salad because, much like Pavlov’s dog” your mouth is salivating from the scene to your right. “I worked hard this week”, you think to yourself. “The kids were out of control and I still have to go home to them” you further justify. There is a tug-of-war of Olympic proportions going on in your brain: Do what you know is right or acquiesce to temptation. Just then the waiter places a piece of paper on the young couple’s table. You wonder: “Is it the check or a referral to the local cardiologist”?
The waiter now turns to you, pen in hand. “I’ll have the _____________” (you know who you are!).
Much like the temptation of the burger deluxe and the brownie supreme, many stock investors are tantalized by the thought of cashing in on penny stocks. We are constantly being inundated with information about the $0.20 stock “ready to explode”. This past week, the BCI site has also had a few inquiries about these securities so I thought it prudent to write this article to help arm our BCI community with the appropriate information.
Here are the qualities most investors define a “penny stock” to have:
- Trade at a low price (under $5 to some, under $1 to others)
- Low market capitalization (# outstanding shares x price); usually under $500M
- Highly speculative due to lack of liquidity (low trading volume)
- Large bid-ask spreads
- Little or no analyst following
- Difficult to obtain corporate information
- Limited disclosure
- Trade over the counter through OTCBB and pink sheets, not on national exchanges
- Manipulation– As these securities are often traded by a single brokerage firm or a small group of firms, artificial buying and promoting can drive up the stock price concealing the real value of the company. A buyer who enters a position will then watch the price decline when the firms start dumping their falsely inflated shares. This is called “pump and dump”.
- Immediate loss due to wide bid-ask spread– If we buy that stock at the “ask” of $0.20 while the “bid” is at $0.10, our shares must double to break even.
- Brokerage overcharge– These firms selling penny stocks will “mark-up” the price they paid for the shares, sometimes as much as 100%.
- Lack of available information– Many of these companies do not file quarterly and annual reports making it impossible to compute the real value of the company.
- Cannot sell the stock– The low liquidity will sometimes make it impossible to sell and the brokerage company may insist in a trade for another penny stock it promotes.
What to look out for:
- Hot stock tip– This can be promoted via the internet, TV, cold calling and emails. In many cases the promoters will be the big winners and we will provide those profits.
- Promises of being insured by the SIPC (Securities Investor Protection Corp)– The SIPC does NOT insure against securities fraud or devaluation of an investment.
- Brokerage licensing– Appropriate licensing and registration still does NOT protect us from fraud. It’s all up to us.
- Bankrupt companies– These companies usually trade in fractions of a penny and will have 5-letter ticker symbols associated with them.
- Erratic trading activity– May be difficult to find a buyer when you are ready to sell.
So most penny stocks are fraudulent companies?
This is NOT true. Not every company that trades for pennies should be considered fraudulent. Many are new companies just starting out hoping to become the next Apple Computer. They aspire to one day trade on the major exchanges. The challenge from our perspective is to find these gems hidden in a field of uncertainty. Once we do, the hope is that the company will actually succeed.
Purchasing penny stock is enticing like the burger super deluxe. However, there are a plethora of risks that we face when pursuing these securities and we must understand and negotiate our way through these challenges before investing our hard-earned money. This site is fortunate to have tens of thousands of visits each month so I am sure that some of you have been successful with this strategy and I congratulate you for that. For most retail investors I say “buyer beware”. For me…I’ll have the salad.
This past week’s economic reports suggest that the economy is recovering enough to prevent another recession but not enough to overcome the unemployment issue:
- The September unemployment rate remained at 9.1%, lower than anticipated
- 103,000 jobs were created; 60,000 were projected
- Job increases for July and August were revised upward
- Consumer debt fell for the first time in 10 months, suggesting caution about borrowing
- Construction activity rose 1.4% in August after declining by that same amount in July
- Factory orders fell by 0.2% in August, however, orders for core capital goods rose 0.9% a positive for business spending
- The index of manufacturing activity increased more than expected to 51.6
For the week, the S&P 500 increased by 2.1% for a year-to-date return of (-) 6.7%, including dividends
Last week a chart was created that showed both the VIX and the S&P 500 were located at the bearish end of recent trading ranges. We looked to see a bullish bounce off these support levels this past week and that’s exactly what we got. The chart below shows a recovering VIX and a rebounding S&P 500:
On this week’s chart (10-7-11) you will note a declining VIX (green field on top) and an accelerating S&P 500 (yellow field on bottom). Both parameters for our evaluation of market tone continue to move in the recent trading range and a definitive trend is yet to be established.
IBD: Market in correction
BCI: Neutral but fully invested favoring in-the-money strikes. We are looking for a bullish technical breakout of the above parameters before taking a more aggressive posture.
My best to the BCI community,
Alan ([email protected])