by James Kelly
There’s no question about it, penny stocks can bring home some of the biggest gains, despite being in the gutter of Wall Street. But, those tiny companies can also bring along quite a bit of risk.
One of the biggest questions asked on stock forums 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 are investing in a business with serious profit potential, or a scamster’s shell game.
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 micro-cap stocks, many of those same protections just aren’t there.
Since the Securities and Exchange Commission (SEC) was created, there have been countless scandals over the years that have clearly shown us that they, the SEC, simply don’t have the resources to make sure that the smallest companies are reporting everything accurately.
Serious listing requirements for penny stocks ensure that shares trading on major exchanges are legitimate businesses, but for the stocks that trade OTC, or on the Pink Sheets, the requirements to get those shares trading are slim to none.
Also, while most investors think of audited financials as a safeguard that keeps a company’s financials accurate, many companies aren’t required to get their books audited, because of their small size.
If you’re thinking about investing in a penny stock that’s exempt from registering with the SEC, you might still be looking at a perfectly good 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 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 a 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 report their financials, 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, 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 or not the financials are accurate, in their opinion.
Checking to see who the auditor is makes a big difference too. Bernie Madoff’s “independent” auditor was not independent – he trusted Madoff too, blindly signing off on the scamster’s financials, and losing millions of his own money 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 issue.
Give Them A Call
Hard-to-find contact information is another red flag that you should watch 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 cautious about going forward with your investment.
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 the customer reviews will also give you an idea about whether or not people are favoring 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 or not 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 some “independent parties” are reporting is unfavorable. These so called “stock promoters” are publishing false research reports, and stock recommendations, in hopes that investors will decide to purchase 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 stocks 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 job, 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 legitimate profits.
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