Penny Stock Scams

On Friday, the Wall Street Journal ran a story about a company with no assets, no revenue and only one employee that has a market value of more than $6 billion!

I immediately had three thoughts.

First, I was reminded of a story that I read in 2000 (I found it online here) during the technology bubble.  One of my favorite authors, Michael Lewis, wrote a column about that had no business operations but was worth $22.9 million simply because it had .com in the name.  How times have changed – this company doesn’t have .com in it’s name and is worth $6 billion!

Second, I thought I should forward the article to some of my colleagues that think the market is perfectly efficient.  I have pretty plainly said that I think the market is efficient, say 75 on a scale of 1-100 where zero is pandemonium and 100 is perfect efficiency.  For the people who say 95-100, explaining how the market puts a $6 billion value on nothing is going to be a tough job (although I suspect it won’t be worth this for too much longer).

Third, I assume that this is some kind of penny stock scam.  The stock apparently didn’t trade much in June, then jumped to $2.25 per share from 6 cents about a month ago and began a rocket ride higher to close at $13.90 on Friday.  According to data on Morningstar’s website, it had traded as high as $21.95 on Thursday.

There is no news yet that this is a scam, but it’s not uncommon in the wild and woolly world of penny stock scams.  In a classic ‘pump and dump’ scam, a scoundrel buys shares of a penny stock like this for 0.06 per share.

He then hires scores of ‘boiler room’ brokers to sell the stock to an unsuspecting public and since there is no liquidity in the stock, the new activity pumps the price higher and the miscreant then dumps the stock for a huge profit.

Years ago, I worked with a guy who had been with a firm like this and he said the movie Boiler Room with Ben Affleck and Giovanni Ribissi is a pretty realistic depiction of the lifestyle.

When you go to the Securities and Exchange Commission’s (SEC) website, there is actually a warning about this, but it’s a little troubling for me because the headline reads: Microcap Fraud.

Since nearly all of our clients have microcap stocks in their portfolio, I want to say explicitly that the microcap fund that we use doesn’t invest in penny stocks.

The fund that we use buys companies that are listed on the New York Stock Exchange, the Nasdaq Global Market and other reputable exchanges.  Those exchanges have requirements including market values, income and asset levels, share prices and shareholders.

Penny stocks, like the one listed in the Wall Street Journal article, generally don’t meet these requirements and therefore trade in the over-the-counter (OTC) market or bulletin board (OTCBB) market (often called the pink sheets), where there are nearly no requirements for listing.

Furthermore, unlike the poor soul who falls for a pump and dump scheme hoping to get rich quick and buys a penny stock, the fund we use is highly diversified.  It has more than 1,800 stocks, the largest stock is 0.57 percent of the fund and the top ten holdings only represent 3.91 percent of the fund.

And while the companies are small, they’re often good-sized businesses.  The average market capitalization is $785 million and some of the larger holdings include brand name businesses as Papa John’s Pizza, WD-40 and Revlon.

It should be no surprise that we won’t touch penny stocks, so if you happen to go to the SEC website, don’t let that headline give you any heartburn!