I got an email from a reader last week that detailed another horrible loss by another naïve penny stock investor. I won’t bore you with the specifics — or even give the stock name, for fear of skewing this microcap on volume — but I’ll just share a choice excerpt:
I ended up missing the boat and it has come down and I have lost quite a bit on it now, upwards of $25K. I haven’t sold it yet and am wondering if I should sell it or if I should leave it and hope it comes up. I really fell into the trap in thinking that it would become another Pinterest type product and get bought up by a Microsoft or Google or some other company. It has gotten so bad I haven’t been sleeping etc.
This sentiment embodies just about every facet of penny stock investing — high hopes due to a flashy promise of big gains, a brief glimmer of profits, then a crash-and-burn that takes a big financial and emotional toll on unlucky investors.
To be clear, I am not trying to publicly shame this person. I am simply trying to share this with the intention of showing — yet again — why penny stocks should be avoided like the plague.
Again, I am not going to name this particular penny stock loser because I don’t want to affect volume. But I did look at the facts — and here are the warning flags from this pick that many other penny stocks frequently share:
No revenue … EVER: I looked at the 10-Q for this pick, and like many pink-sheet penny stocks, it has never generated a penny in revenue. This despite being formed in October 2004! I’ll admit good companies are started all the time that have zero revenue out of the gate … but if you have no customers after eight years, that’s just ridiculous.
Shady share exchanges: The biggest red flag for this social media company is that it was minted in June 2012, formed by a share exchange with another microcap company focused on the natural gas business. Uh … what? Explain to me how those are compatible. Furthermore, this “buyout” happened without a penny in cash, but simply a swap of stock. When two unrelated, money-losing microcaps join forces, it’s rarely a sign of good things to come.
Flashy marketing angle: From the start I knew this would end badly since this company branded itself as social media company — right in time for the Facebook (NASDAQ:FB) IPO buzz, the massive $1 billion buyout of Instagram and an explosion in interest around Pinterest. If you know anything about shady penny stocks, you should know they frequently use a flashy pitch — such as zero-emissions energy or cloud computing or social media — to justify why they are the next big thing.
If you are addicted to penny stocks, please please PLEASE look at the filings … and keep your eye out for red flags like these.
You’d be amazed the painful admissions of ineptitude that come out in SEC reports. Kid Dynamite of StockTwits took a deep dive into a penny stock earlier this year with some darkly funny results that is a must-read for anyone investing in microcaps. It lays bare some of the shenanigans that go on — and that investors could be aware of if they only looked at public filings.
Here are a few more rules of thumb for penny stock investing:
- Always use limit orders for buying and selling, and do so during market hours. Low volume means volatility. An open-market order of just a few thousand bucks could skew pricing wildly.
- Be judicious with your stops. Not too tight, since volatility risks stopping you out during a brief downtrend, but tight enough to prevent losses of 30% or 50% or more if things implode.
- Never chase performance. Volatility always swings both ways, and it’s rare a penny stock has a sustained rally for weeks or months. If a penny stock pops 50% in five days, expect the sellers to cut and run very shortly.
- Never hold more than a handful of penny stocks. Since these are almost pure sentiment plays, it doesn’t make sense to fool yourself into the illusion of “diversification” here.
- Only bet what you can lose. This is the most aggressive style of investing out there, so don’t gamble with money you need for retirement or the mortgage. Keep this a hobby, not a livelihood.
- Make sure you have other retirement plans. It’s willfully naïve to think this kind of penny stock investing can deliver consistent returns over the long term. A handful of traders can probably prove me wrong, but the vast majority are better served in conventional indexed funds or other vehicles.
- The latest penny stock scam unwound by the SEC: A company called Electronic Game Card Inc. is bankrupt after its execs “played a game of make-believe with a publicly-traded microcap company.” This is your asset class, friends. (SEC.gov)
- How do you spot a penny stock scam artist? (InvestorPlace)
- Why low volume always trumps any “analysis” of a microcap. (InvestorPlace)
- Tom Taulli reminds investors that OTC and pink-sheet microcaps are always alluring, but very often wind up worthless. (InvestorPlace)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.