STOCK SCAMS, SCHEMES AND SCUMS:
Watch Out for these 10 Major Warning Signs
After reading this web site I get the feeling René is
laughing "All The Way To The Bank!"
financialweb.com
By The Stock Detective
Sponsored by WallStreet Guru
Wherever there's money to be made -- meaning just about everywhere -- the potential for fraud and deceit abounds. In a United States stock market amassing trillions of dollars and listing over 20,000 publicly-traded companies, only a fool believes that the next scam might not await in your next home mail delivery or incoming telephone call.
Every investor dreams of discovering and owning shares of the next Microsoft or Intel, one-time small stocks that now rank among the world's best-known and best-run companies. Unscrupulous stock promoters and brokers -- and sometimes company management as well -- prey upon this greed, offering pie-in-the-sky pitches for low-priced stocks boasting the latest "revolutionary" product or "21st century" technology.
All too often, these companies are all sizzle and no steak. That revolutionary product or technology is only a concept, with no product or technology at all -- and no revenues and no future. There may not be even the slightest intention of making and selling a product, only to pump up the stock price and dump the shares at a big profit.
In the classic "pump and dump" stock scam, a company whose officers own large numbers of shares in its stock issues thousands or millions of shares at below-market prices, or even for free, to a promoter and affiliated brokers. The market is then artificially inflated through demand created by the brokers, using pushy, high-pressure sales tactics to lure unsuspecting investors. After a substantial boost in the share price, the insiders take their profits and the stock plummets. Novices often don't realize what is happening and cannot sell in time.
The stock price may spiral back to its original levels, or even nosedive to zero. Meanwhile, the insiders line their pockets with the stock proceeds. The promoter perhaps will move on to the next deal but the company, after a reasonable interval, may recruit a new promoter to pump and dump the stock again. Some companies are merely stock churning vehicles, whose top officers have little interest in creating a real business with viable products or services.
As investors become more educated and sophisticated, many have grown wise to the old penny-stock "boiler room" operations. Unfortunately, this does not mean that stock scams have dried up. The scammers simply have become more sophisticated as well, perhaps utilizing Internet or professional direct mail resources to target new suckers.
It is possible, however, to observe important warning signs of potential small-stock scams. For starters, use simple common sense: caveat emptor, or "let the buyer beware." It requires a bit of investor homework, however, to discover most of the warnings, and even more to determine whether they signal serious trouble. And if you're not willing to do the homework, then you should not get involved in small stocks -- or any stocks, for that matter.
Consider these 10 warning signs of potential small-cap stock schemes, scams and scums -- and ignore them at your peril:
1. Watch out for aggressive broker sales calls!
An unsolicited telephone call from an aspiring broker is not necessarily a bad thing, even if he or she has interrupted your coffee break or your evening meal. Every broker, even at the Merrill Lynches and PaineWebbers of the financial world, earns his stripes by smiling and dialing. But if he starts spouting on about "the unique opportunity that just crossed my desk," watch your wallet.
Trading in small-cap stocks or penny stocks can prove extremely lucrative, with broker-dealers and individual brokers raking in massive profits far in excess of what is attainable in the mainstream of the securities brokerage industry. With so much potential gain at stake, some brokers can't resist the temptation.
Especially when there are only one or two market makers, small-cap stocks are susceptible to price manipulation. Broker-dealers are sometimes able to acquire a large holding of one of these stocks at a very low price, then the brokers' sales force hypes the stock through high-pressure sales tactics.
Forbes magazine recently cited an example of a common broker cold-call strategy practiced by Dickinson & Co., a penny-stock brokerage firm, involving a two-call system. The first call is relatively low key: "My name is Joe Smith and from time to time I get some very good stocks. May I call you the next time I get one?" The second call is the hard sell: "I'm not calling you today to waste time or play games. I have what I believe is a very exceptional situation. I'm offering it only to my best clients and a few prospective clients like yourself."
A good broker doesn't have to resort to pressure tactics, and he doesn't try to dazzle people by slinging market jargon around. Furthermore, a good broker will advise that you spread your risk among more than one investment. Don't fall for "hot tip" brokers that try to convince you that there is a fast buck to be made. There is -- for them.
In fact, the best defense is to just say no. Never buy investments offered over the telephone. Always ask for information about the investments in writing so you can review it. And if you're offered a deal that sounds too good to be true, it probably is!
2. Watch out for promotions disguised as unbiased information!
If they can't get you over the phone, they may try to get you through the mail. Woe unto you if you're one of those unfortunate individuals that receive small-cap company direct mail promotions, because somehow you have been identified as a prime sucker in the "pump and dump" game.
Many of these promotional pieces are highly professional in appearance -- glossy and colorful, with sophisticated graphics. They likely will include photos of cute baby ostriches scurrying around that ostrich farm where "profits are set to soar," or grim photos of the festering mountains of filth and garbage that will soon disappear, thanks to the company boasting the latest "revolutionary" recycling technology.
It is critical to understand that the vast majority of research reports touting a stock listed on the Nasdaq small-cap market or the over-the-counter bulletin board are no more than paid advertisements. In other words, the company has paid a fee to an investor relations firm to produce and distribute company profiles which, as the old song goes, "accentuate the positive and eliminate the negative."
You won't find a word in the latest LottoWorld (Nasdaq Small Cap: LTTO) corporate profile, for example, about the $10 million in operating losses the company amassed during the previous two years. Recent promotions claim Commerce Group Corp. (Nasdaq Small Cap: CGCO) is "poised to become one of the world's major gold producers," yet the gold it has produced in proportion to its reserves ranks among the lowest in the mining industry.
Even press releases should not be trusted. Like corporate profiles, press releases are designed to highlight favorable developments only. In fact, small companies often hire investor relations firms -- the same happy folks who create the biased corporate profiles -- to write their press releases! Additionally, the company that churns out a continuous stream of corporate profiles and press releases may be too busy promoting itself and not busy enough in building its business.
The corporate profile and press releases may provide interesting reading, but they are no substitute for the company's prospectus and 10-K statement. For many small publicly-traded companies, little or no analyst coverage is available. The prospectus and 10-K may be the only unbiased, untainted information sources you can find.
No matter what the glossy literature says, get a prospectus and read it all the way through. If the stock is more than one year old, get the most recent 10-K and read it all the way through. Anything in the prospectus or 10-K that contradicts your previous understanding of the facts should be a red flag.
3. Watch out for obfuscation, confusion and pie-in-the-sky promises!
Why would some companies choose to be quoted on the "Pink Sheets," or the OTC Bulletin Board? Actually, many fledgling firms don't have a choice, since they are unable to satisfy the minimum listing standards for the Nasdaq National Market or even The Nasdaq SmallCap Market.
But promotional literature sometimes inaccurately lists the stock as "Nasdaq Bulletin Board." Nasdaq would want you to know that there is no such thing, that these stocks are not authorized for quotation in the Nasdaq system and are not part of any major national securities market.
Often that obfuscation of a basic fact is deliberate. And if a company or its promoter will lie about such a small matter, what else will they lie about?
Try this: Unspecified claims of "major" developments, such as a "pending" acquisition or an "imminent" distribution agreement with a well-known company, are common distortions featured in scam stock promotions. Maybe an announcement is truly forthcoming, or maybe somebody made one phone call. But it makes a more exciting story to tell, and that's all that really concerns the unscrupulous promoter or broker.
Or this: Dramatic increases in projected sales or earnings. For example, Havana Republic (OTC Bulletin Board: HVAR), a cigar manufacturer which began operating only in 1996, says it expects to sell five million cigars in 1997. Toppers Brick Oven Pizza (OTC Bulletin Board: TBOP), a company with no reported income in 1996, forecasts $27 million in 1997 revenues and $165 million by 1999.
These firms may actually believe their pie-in-the-sky projections, but you shouldn't. Even projections from the biggest and most established companies should be viewed with caution. Outlandish projections from small, unproven companies are hardly worth the paper they're printed on.
4. Watch out for weak fundamentals!
Fundamental analysis is not unique to the larger-cap stocks on the New York Stock Exchange or the Nasdaq National Market System. One may analyze the financial statements of their small-cap brethren as well to gather clues of investment worthiness. It's all in the financials.
Firms with a strong track record of three to five years of sales and earnings growth of 20-30 percent per year, for example, may offer promising investment opportunities regardless of where the stock is listed. Companies with little debt, preferably no more than 25 percent of total capital, can better bankroll their expansion.
On the flip side, young companies often have very high profit margins and high returns on equity but, when competition starts to make an impact, profit margins and revenue growth likely will decline. Beware these situations when evaluating a small-cap stock:
· The stock sells at a much higher price-to-earnings multiple than its recent sales growth rate.
· The stock sells at a valuation of more than three times total revenues.
· The company's total market capitalization exceeds the size of the total market its products will serve.
· The company's income statement reveals unusually excessive general and administrative expenses
· The company's cash flow statement shows losses from operations in contrast to net earnings
· The company has nothing but a concept and generates no revenues.
Cheap stocks aren't always cheap because they're second-rate companies. Plenty of small-cap companies truly possess a promising product or service that has yet to hit the market. In the absence of sales or profit-generating assets, you must attempt to quantitatively judge the value of future products -- an extremely difficult task unless it's a business you thoroughly understand.
It is equally critical to judge the quality of the people running the business, and there are some effective warnings to consider:
5. Watch out for excessive executive compensation!
Meet Angelo S. Morini, Chief Executive Officer of Galaxy Foods Company (Nasdaq SmallCap: GALX). During fiscal year 1996, Morini received a base salary of $250,000. He owns 18 million shares of company stock, worth $13-$14 million at current market value, which he purchased not with cash but with a note payable due in 2000, when he may extend the note for up to five additional years. Galaxy Foods covered $9,107 in lease payments for Morini's automobile and $5,597 in club dues during fiscal 1996. Again, it's all in the company's financial statements.
Galaxy Foods suffered nearly $8.5 million in combined losses during fiscal years 1995 and 1996. So Morini is rewarded handsomely for his questionable leadership of the company. And there are lots of Angelo Morini's in the world of small-cap stocks.
The controversy over excessive executive compensation isn't unique to small companies, of course. But capital at small companies is far more scarce, and limited resources usually are needed to fund ongoing operations and stimulate growth. High salaries, generous options and other perks are all legal, but not exactly a sound strategy for successful long-term business development. Do you really want to invest your hard-earned money so that someone else can live a life of luxury?
CAYMAN
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