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The skinny on penny stocks

The term "penny stock" is one that can either strike fear and skepticism into the hearts of investors, or alternatively, suggest the possibility of great opportunity to make many times an initial investment in a relatively short period of time in a little-known company.

"Penny stocks are a fascinating, shadowy underground world, including micro-sized, but legitimate, businesses looking to raise equity capital. (They can include) legitimate but speculative entities, out of favor stocks, companies entering or emerging from bankruptcy, dormant corporate shells waiting for a buyer, criminals looking to steal people's money, and everything in between," says Arthur Patten, president of Symmetry Capital Management LLC, in Jenkintown, Pa.

Complicating matters for investors is the fact that recent market activity has pushed many companies' stock prices below $1 a share and has blurred the lines between penny stocks and those that simply trade at a relatively low price.

"Anytime there's volatility, there is always going to be a way to get rich quick, and con artists will prey upon that," says John Stark, chief of the Office of Internet Enforcement at the Securities and Exchange Commission, or SEC.

With market conditions apparently ripe for penny stock trading and scamming, Bankrate offers this primer on the class of securities known as penny stocks.

The SEC defines a "penny stock" as low-priced shares of small companies that typically trade infrequently, generally over the counter and not on a stock exchange. It is sometimes difficult to find price quotes on these companies and to obtain accurate pricing. The SEC warns that investors who invest in such securities may be at risk of losing their entire investment.

"You should, in general, take the same approach to choosing a stock that you would take in choosing a heart surgeon. Talk only to people you really trust. When you're talking about buying a stock, you're talking about your future," says Stark.

While that's true of nearly any type of investment, the risks in penny stocks may be even greater for several reasons.

Penny stocks are sometimes recommended and sold as a result of fraudulent activity to induce investors to take part in what amounts to a "pump and dump" scheme. Those involve the dissemination of overly optimistic claims about a particular company's prospects, via e-mail and press releases, or on message boards to "pump" up the price of the stock, the SEC says.

Symmetry Capital Management's Patten is especially skeptical of some "newsletters" pushing penny stocks. "One of the earliest clues in these and some other types of scams is the promise of staggering returns for only a small subscription fee," Patten says. "In those cases, the best you can hope for is that the author and publisher only make money from subscription fees.

"The worst case explanation is that they stand to benefit substantially from any interest in the stock, however transient. In other words, you're going to end up putting more than a subscription fee in their pockets!" Patten says.

Because many such companies typically trade infrequently, a small increase in purchase activity may cause the stock price to rise, sometimes quite precipitously. At this point, the sources of the original positive information sell, or "dump" their shares, often at a huge profit. Victims of this scam are lucky to recoup any significant portion of their original investment.

"While professional institutional investors should be better able to defend themselves against scammers, penny stock scammers deliberately target people who are less experienced and knowledgeable," says Patten.

One recent "pump and dump" involved VMT Scientific, a Nevada-based shell company that Stephen Roebuck, a stock broker, and Daniel Kaiser who served as the company's chief technology officer, took control of in 2005. According to the SEC, after issuing 120 million shares of stock and transferring them to offshore brokerage accounts, Roebuck and Kaiser began promoting the company through press releases and a Web site which made false claims about the company's medical breakthrough product. They purported that the product lessened the chances of amputations brought on by complications of diabetes.

"The only thing that's predictable (about a penny stock scam) is when there's something that's exciting -- a new chip technology, an anthrax prevention product, a car that runs on water -- there are going to be professional con artists who will try to put up a pump-and-dump scheme," Stark says.

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Unfortunately for those investors that fell prey to the VMT scam, not only was the product nonexistent, the company had no revenue, no operations and was under the custody of the courts. At one point, as a result of the false news, the stock price increased by more than 400 percent, and Roebuck subsequently sold 9.5 million shares for about $990,000.

"The typical penny stock doesn't have as much information and may not even have a place to call or a headquarters, so you have to be extremely careful," Stark says.

Buyer beware

Reliable data and information about penny stock companies are often difficult to obtain. Because the SEC typically regulates companies with more than $10 million in assets and more than 500 registered shareholders, most penny stocks are not required to file financial statements. This leaves a gaping hole of information available to prospective shareholders, and scammers often fill the gap with false claims. Prospective investors may turn to message boards, where it is very difficult to know with any certainty what is behind a particular posting, the SEC says.

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