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.

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.

Most penny stocks don’t trade on a stock exchange but rather an electronic over-the-counter quotation system such as the Pink Sheets or OTC Bulletin Board. The Pink Sheets is a privately owned centralized quotation service that collects and publishes the bid and ask prices of securities from selected stock brokerages known as “market makers,” the SEC says. The name “Pink Sheets” comes from the color of paper that quotes were historically printed on. These securities are too small to qualify for listing on other exchanges such as the New York Stock Exchange or Nasdaq.

The OTC Bulletin Board, or OTCBB, is an electronic quotation system that displays price quotes for over-the-counter companies or those not listed on exchanges. It is operated by Nasdaq and overseen by industry regulator FINRA, or the Financial Industry Regulatory Authority. Unlike companies on the Pink Sheets, companies quoted here must be fully reporting and be current on required SEC filings. But there are no requirements for minimum price or market capitalization as there are for companies traded on the major exchanges.

Pink Sheets reputation

However demonized they’ve been, there are many legitimate, sound companies trading on the Pink Sheets. Such a quotation system for the smallest of the small has actually filled a gap, creating a marketplace for companies that otherwise would not be able to trade.

Jack Norberg, chairman of Standard Investment Chartered Inc., of Costa Mesa, Calif., which trades in microcap stocks, suggests that “just because a company does not have 500 shareholders, doesn’t mean it’s not a good place to invest for the long term.”

“The key research effort is to separate the weak promotional companies from the strong shy types,” Norberg says.

Still, given the lack of information and lack of liquidity, most investors should steer clear of Pink Sheet companies unless they have the time and skill necessary to adequately research the companies trading there, Stark says.

“There’s no reason to rush into any investment. Period. If you miss a few points on the upside because you were careful and thoughtful, you’re still going to be better off,” Stark says.

To help investors, the Pink Sheets added some disclosure in August 2007 in the form of three categories for companies being quoted in order to provide investors with more information, according to its Web site. They are:

  • Current information for companies that do submit regulatory filings and make them available.
  • Limited information for companies with financial reporting problems or in financial distress or bankruptcy.
  • No information for companies unable or unwilling to provide disclosure to regulators, exchanges or the Pink Sheets. It may include defunct companies or companies with questionable management and market practices.

The Pink Sheets also have a “caveat emptor” category, which includes companies under investigation for fraud, or those with spam campaigns or questionable promotion activities. Stocks in this category will have their quotes blocked by the Pink Sheets, meaning that stock quotes for these companies will not be listed.

Penny stocks or just stocks?

With a major pullback in stock prices through early March of this year, many companies have seen their stock prices fall to less than $1 a share. This includes former blue chips such as Citigroup and AIG, as well as Office Depot, which all saw their stock prices decline over a variety of financial concerns.

Although each of these companies fell below a dollar, none of them met the traditional definition of a penny stock. For one, all of these companies trade and continue to be listed on the New York Stock Exchange, all are required to file with the SEC and information about them is readily available.

“No matter whether they’re public or private, regulated or not, all businesses face the risk of failure. While it makes sense for most investors to buy an index of many companies, those who are going to invest in an individual business have to do their homework. That means digging into a public company’s filings, not just accepting them at face value,” says Patten.

Given the beating that many investors suffered during 2008 and early 2009, there may be the inclination to try to make up for lost capital by investing in lower-priced companies where a small move in share price can result in big gains. This is dangerous territory, especially in the penny stock arena.

“Unfortunately, this environment is probably a bountiful one for hucksters promising massive short-term gains to hopeful investors who are desperate to regain lost wealth. But keep in mind that you’re likely to just end up surrendering part of your remaining wealth to them,” Patten says.