Penny Stocks - The Good, the Bad, the Ugly

Most Penny Stock companies start out the same way: An entrepreneur lists a company on a (usually) junior exchange to raise financing for a new venture. If they're competent, they know they'll want to promote the share price so that the stock is worth more than the company. In this way, management can sell its shares to investors and maintain as much control over the company as possible. Then using the capital, and incentivizing themselves with cheap options, management attempts to develop a profitable company whose share price is eventually worth the promoted share price…and hopefully much more.

Most actively traded Penny Stock companies also share most of the following characteristics:

• Marginal or no sales
  
• Marginal or no cash
  
• Non recourse debt owed to "friendly" shareholders without recourse or time for repayment
  
• Little or negative shareholders equity
  
• Few or no assets
  
• Some form of intangible debt or "goodwill"
  
• Few or no employees
  
• An "incredible story with insane potential" to either become massively profitable quickly or to change the world as we know it
  
• Sometimes, a talented CEO or other executive that has a reputation or blue chip experience
  

Before we ask how they can be categorized, we may want to ask...why should we? Because there are significant differences that allow the astute investor or speculator to determine which penny stocks to invest in, and which ones to stay away from.

Since they all look alike, you may ask how they can be classified. Most penny stock investors have been taught to look at management and structure of the company. The truth is, it always, always, always, depends on the promoter. The best company in the world without a competent promoter will not make a dime for anyone, including management and early shareholders.

So it logically follows that the companies we're looking at investing in can be categorized by categorizing the promoters. And these promoters fall into atleast five classes that I'm going to introduce you to in the next series of blog posts. Stay tuned. This will not only be informative and entertaining, but if you get it right, very profitable for you.

Or you can let me do all the work for you and subscribe to my stock picks at http://www.pennystockjockey.com/

Penny Stocks, Bulls, Bears and Promoters

Unless you've been living under a rock, you've no doubt noticed the action taking place in the penny stocks sector. There are a few things to take particular note of:

• The action isn't discriminating against any penny stock company or favoring any penny stock sector
• Its happening during what some call the beginning of a bull market
• Its happening during what some are calling a bull rally in a bear market
  

What this tells me, and what it should tell you, is that money doesn't discriminate among penny stocks. So the big question in your mind should be what makes some penny stocks move, and others not?

It's not the charts; every penny stock has a different chart...and a different capitalization structure. Every company, if it wants to can tell a compelling story. Most of these penny stocks are similar in terms of their income statements and balance sheets.

Vive La Difference!

So what is the elusive difference? Simple: penny stock promotion. While some companies out there is trying to figure out whether we're in a bull market, or a bear market, penny stock companies that have employed a good stock promoter are increasing their valuations; it doesn't matter if its a bull market or a bear market or a bull rally in a bear market. The right stock promoter will always be able to work within the confines of a free economy.

So Does the Promoter Matter?

Absolutely. The reason I keep mentioning the right "stock promoter" is because the wrong one can completely destroy a company. Its been proven in the past that SPAM does work. - for the spammers. These days, most often, once a stock is spammed, pinksheets puts out a skull and crossbones on the stock and large online brokerages like Ameritrade, Etrade, Scotttrade and Schwab will not allow online trading in the stock. So the company hiring the wrong promoter really does suffer.

Where's the Advantage?

Unless you've been investing in penny stocks for a long time and know the game, its hard to tell the players without a programme. You could sign up for anyone of a multitude of free penny stock pick sites, but generally you'll get what you pay for. These companies are paid to tout stocks having done almost no research, and without even looking at management.
Or you could subscribe to a site that doesn't take any compensation from the companies it profiles. The site, www.pennystockjockey.com takes no compensation from any company we profile. Further, if the company profiled has a market cap large enough (generally anything over $20 million) we'll pay for an independent CFA report to justify our own conclusions. And ofcourse, the whole premise behind the company is that WE KNOW THE PROMOTER behind the deal. We will never recommend a company that isn't interested in promoting its stock, and we're not interested in profiling a company not willing to hire the right type of promotional services.

Are All Penny Stocks Created Equal?

Amazingly enough, a number of American financial sector stocks were thrown into penny stock realm in the past two weeks. In the past few months, even bigger banks declared bankruptcy.

The SEC defines penny stocks as “low-priced (below $5), speculative securities of very small companies. While penny stocks generally are quoted over-the-counter, such as on the OTCBB [www.otcbb.com] or in the Pink Sheets [www.pinksheets.com], they may also trade on securities exchanges, including foreign securities exchanges. In addition, penny stocks include the securities of certain private companies with no active trading market.”

By this definition, the financial sector stocks – stocks like Citibank and Bank of America, are penny stocks.

Last fall, the SEC took the unprecedented action of banning short sales and calling for a short cover on financial sector stocks that had been beaten down by the shorts. It’s a lament that penny stock companies have been complaining of for years, but went unheeded.

And now these established, down-on-their-luck financial companies have convinced the American public that they are deserving of billions in taxpayer dollars because they are established companies and not traditional penny stocks as defined by the SEC.

So what have we really done for these behemoths? We’ve altered the definition of penny stocks to accommodate them. We’ve altered the level playing field by exempting them from short sellers. And now we’re giving them tax dollars like some government sponsored clinic while hard working entrepreneurs have to fight for their place in this shrinking economy.

Are these billion dollar bailout babies really that different from your traditionally defined penny stock?

Traditionally, risk characteristics attributed to penny stocks include:

1. Penny stock companies are usually start ups that lack of information about the company, its history and its management. I would argue that financial sector companies suffer from the same lack of transparency. After all, how could anyone not see the leverage and the misguided asset classifications and still invest in these behemoths? The derivatives are way too complicated for the layman to analyze…so we rely on the banks to tell us the truth, while they have a conflict.

2. Large control blocks. Penny stock company founders traditionally have a large block of stock (albeit restricted) to ensure their interests are aligned with the rest of the shareholders while ensuring they cannot sell their shares for a quick profit at the detriment of other shareholders. In the financial sector, these large blocks are held by fund managers – who similarly cannot sell their blocks quickly without lowering the market price and thereby impairing the return to themselves. What’s more, the CEO’s of the companies barely have any stock in their portfolios – eliminating the alignment with shareholder values. Instead, it’s become vogue to pay these CEO’s via stock options – giving them an incentive to show short term results and then cash out their options while the rest of the investing public holds shares that were sold by insiders.

This is done by using unwitting brokers, paid analysts and unquestioning media to tow the company line. And because the CEO’s and the companies have been held in high esteem, no one questions the use of these tools or their motives.

Penny stock companies often use similar tools – only with a penny stock it’s called stock promotion. And penny stock companies have better motives: without stock promotion, the best company in the world won’t be worth anything because no one would have heard of it – and therefore the enterprise would be hard pressed to raise money for growth. Promotion is a driving investment criterion for choosing a stock to invest in at www.pennystockjockey.com.

The issue with promotion is that the SEC often believes that stock promotion involving a penny stock needs more supervision than the promotion being conducted by billion dollar house hold names. Is there in fact an opportunity for fraud in the penny stock market? Of course there is.

But I contend that the risk is much higher with well established companies that have CEO’s holding stock options (big motive for early liquidation since options expire) rather than actual restricted stock (unsellable) for which they actually paid (as many penny stock companies experience). Empirical proof is offered by the billions lost in the financial sector right under the nose of, and with the blessing of the SEC and other regulatory bodies than has ever been lost on penny stocks.

3. Potential for fraud. Penny stocks are often used by scam artists who sell them through spam email or off-shore brokers. As the recent IRS/SEC probes have proven, many, many, many American CEO’s have offshore accounts making them no more honest or dishonest than the operators of penny stock companies.

Both traditional penny stock startups and the fallen as exemplified by the financial sector have the potential for growth and for fraud. Both are blighted by cash requirements, by short sellers and by image problems.

The difference is that the fallen companies have the government and SEC fighting for them while the typical startup penny stock company is vilified. The dichotomy is even more surprising when we stop to think that economists have long been telling us, and the American experience has long proved that the start-up is what drives the economy, diversifies the job base, creates the most jobs and is lean enough to take advantage of changing times.

So I ask you America: Are all Penny Stocks Created Equal?