Once again: by The Stock Detective
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 broker 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?
6. Watch out for suspicious backgrounds!
In your prospectus, carefully review the backgrounds of company management. Does at least one member of top
management among the president, chief executive officer or chief operating officer have substantial previous
experience in the company's primary line of business? Does any part of their backgrounds indicate experience
with entrepreneurial or turnaround situations? Did any of these situations ultimately result in the establishment of
successful, ongoing businesses?
If the company officers' dominant overall experience involves "investment banking," beware. This situation may be
no more than a bunch of ex-brokers that have obtained a shell company to play with. This group will know how
to move the stock, but probably little about the industry it's joining. Their intentions may be pure, or they may be
out to lure gullible investors into a "pump and dump" scheme.
And review each of the officers listed in the prospectus. If the list of top officers and/or major shareholders is
stacked with the CEO's in-laws, you're probably better off finding an opportunity elsewhere.
Don't get burned by management lacking proper quality and preparation -- or motives. Let them play with their
own matches.
7. Watch out for involvement in unrelated businesses!
A mortgage processing company that becomes a casino company... overnight? A resort management firm that
branches off into... cosmetics? Not exactly matches made in heaven. But they are actual examples of
publicly-traded small-cap companies -- Advanced Financial (American Exchange: AVF) and ILX Inc. (Nasdaq
Small Cap: ILX), respectively -- and ones that also happen to have a history of excessively promoting their stock
to the investment public.
When confronted with such a company, the prospective investor should ask: Why would a development-stage
company, which has yet to successfully develop its primary line of business, attempt to establish a completely
different, unrelated business?
We don't know the specific motivating factors behind the moves of the above small-cap companies and others
like them. Perhaps it's just pure stupidity. But sometimes these are signs of a company not really interested in
building a long-term business. Sometimes these are signs that the company's top management, who are also the
controlling shareholders, are trying to temporarily pump up their shares at the expense of gullible small investors
-- and then sell out.
Whatever the reason, you don't want to be a part of it.
8. Watch out for reverse splits!
Here's how a reverse stock split works. A company's stock currently trades at
$1. The company implements a one-for-five reverse split. Every five shares of
pre-split stock becomes one share. The investor, who had previously held
1,000 shares, now owns 200 shares of the post-split stock. The new stock
price immediately after the split is $5. The market value of the position, before
and after the split, is $1,000. What could be wrong about that?
Because when such a reverse split takes place, it's often a glaring indication
that all is not well at the company. True, the shareholder does not suffer a loss
of asset value or a dilution of ownership value. But this equality is usually very temporary.
When a company undertakes a standard stock split, things are usually going well. The business operations are
profitable and growing, and the shares are moving steadily upward. Such is almost never the case for the
company implementing a reverse split.
Pure and simple, reverse splits are facilitated to improve the appearance of the company and its stock price. The
company whose stock is $5 appears more valuable than one whose stock is merely $1. But if the company really
believed in its future and wanted to reduce its amount of outstanding shares, it would start to buy them from the
market.
Furthermore, the stock is now ripe for a secondary offering of more shares by the company. For the pre-split
shareholder, his percentage ownership in the company will endure a magnified degree of dilution the moment the
new shares hit the market. The company's objective for the share offering has yielded the desired capital, but the
risk has been transferred to the shareholders. It makes no monetary difference to the company.
9. Watch out for Regulation S abuses!
Regulation S is a section of the federal law that permits publicly-traded companies to sell unregistered securities
to overseas investors. These "overseas" investors, in some cases, are actually U.S. investors operating through
offshore shell companies, often hedging their investments by using options or short sales. That's particularly true
when the issuers are risky small-cap companies, which sometimes turn to Reg S offerings out to sheer
desperation for cash.
In the past, these Reg S securities could be issued to the "overseas" investors and then sold back into the US
market before the existing shareholders even found out it. But the SEC realized that this was a problem and
recently changed the rules. A company that issues Reg S securities now must file a Form 8-K within 15 days of
its occurrence. Because Reg S securities are currently restricted for 40 days after they are issued, existing
shareholders will be warned about Reg S deals before the shares can be sold. However, purchasers of Reg S
securities can still short the stock before the 40 days are up, and later use the Reg S shares to cover their short
position. Therefore, existing shareholders can get hurt by Reg S offerings even under the new rules.
The most dangerous kind of Reg S offerings for existing shareholders are convertible securities which can be
converted into common stock at a fraction of the stock price at the time of conversion. For example, the
securities might convert into common stock at 75% of the average bid price over the previous five trading days.
No matter how low the stock price falls, the Reg S investors can still convert into common stock at a price lower
than the current stock price. And the lower the stock price falls, the more shares they get. Therefore, they benefit
from the dropping stock price and will often even short the stock to help it fall further (and lock in higher sale
prices of the stock as well), then cover their short position with the shares they get from conversion. They almost
can't lose! The existing shareholders, however, are usually big losers when this happens.
This type of Reg S offering will frequently cause a massive increase in shares outstanding, which means that
existing shareholders now own a smaller piece of the company and hold shares that are worth much less than they
were before. Watch out for all Reg S offerings, but especially watch out for this type of Reg S!
10. Watch out for the little things -- they can add up fast!
Little things mean a lot: It's true in all walks of life, and evaluating small-cap stock opportunities is no different. If
the fundamental analysis, pie-in-the-sky promises or management resumes are inconclusive, other seemingly
inconsequential minutae buried in the prospectus can flash as clear a warning as any.
Observe the list of market makers. Research the kinds of issues each firm underwrites, if possible. Has the
market maker engaged in a history of small-cap activity? If so, how have those stocks performed? If the
company has only one or two market makers, the stock stands highly vulnerable to price manipulation. The more
market makers exist for a given stock, the more likely they are to bid against each other and the price will more
likely move to a true "market" price.
Note the filing date required by the SEC, posted in the company's periodic financial reports. If the filing date is far
out of whack with the report date (i.e., December 31, March 31, et. al.), this is a delinquent filing and probably
symptomatic of much deeper problems. (Companies have 45 days from the end of a quarter to file a 10-Q and
90 days from the end of the year to file a 10-K.)
Study the stock's trading history. Are there any unexplained trading suspensions? Has a typically thinly-traded
stock experienced sudden and unexplained surges in trading volume? Is there are a sudden dilution, or history of
dilution, in the number of shares outstanding? When promoters obtain huge numbers of shares at deeply
discounted prices, or for free, the holdings of the other shareholders is immediately watered down.
Finally, don't forget to check the section covering litigation and investigations. The prospectus will disclose all
lawsuits filed against the corporation, as well as any pending government investigations. If this section paints a
dark picture, stay away from the stock.
When it comes to small-cap stocks, trust no one except yourself and your sound judgment. You'll have no
trouble finding small-cap companies that will trip over themselves highlighting their positive points; they're not so
forthcoming in revealing their negatives. The truth is out there -- but, like the conspirators in The X-Files, it is
sometimes hard to find.
Conclusion: Things Are Looking Up
Despite all of the problems with small-cap stocks, there are many legitimate companies whose securities trade on
Nasdaq and on the over-the-counter market at very low prices. After all, struggling young companies have to
start out somewhere. Investment in such companies, held through the formative years, can pay off extremely well.
Over the past decade, the SEC has instigated many market reforms and Nasdaq officials have tightened scrutiny
as well. As a result, the managements and fundamentals behind many small-cap companies have dramatically
improved. Some of these firms represent the best relative bargains in the market today, and they grow and
prosper in relative obscurity.
Internet sites such as this one can assist your search. But you must search hard. And never stop looking for the
pitfalls along the way. |
