Penny-Stock Pitches Can Cost You Dollars

EDITOR'S NOTE: This article was originally published in the June 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.

Don't be surprised if someone leaves a message like this on your cell phone: "Hey Bob, it's Charlie. I know you guys were upset that I didn't give you a heads up about my last big score. But I gotta tell you, I'm buying a stock now that's gonna go through the roof."

What sounds like a message left in error has actually been sent to thousands of cell phones to entice people to buy a penny stock. In this cell-phone wrinkle on the classic pump-and-dump scheme, the operators gradually buy up a large number of shares of a cheap stock. Then they create enough buzz to attract buyers.

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When the resulting demand boosts the share price, the promoters sell out, leaving investors with worthless stock. Unfortunately, investors struggling to recoup losses suffered in the bear market are increasingly vulnerable to this siren call of quick profits.

There is no hard definition of a penny stock, but it is usually one selling for less than $5 a share and is generally thinly traded on over-the-counter systems rather than on stock exchanges. Many are legitimate start-ups, but unlike companies listed on the major exchanges, these businesses rarely attract the attention of Wall Street analysts. Their low share prices and opacity make it easy for operators to manipulate the stocks.

Consider the promotion of a biofuels company. Late last year, a publication called Clean Energy Review appeared in the mailboxes of thousands of investors. It touted Universal Bioenergy, a Nettleton, Miss., com-pany that plans to turn restaurant grease into fuel, as an "undervalued" stock with "profit potential."

Although it looked like an investment newsletter, the publication carried a "disclaimer" in tiny print that said it was really a "print advertising effort." It also said one company had paid another $590,000 to create the ad. (No address was listed for either firm, and our efforts to track them down were fruitless.)

In a separate pitch, a Web site that looks at penny stocks gave Universal Bioenergy a "speculative buy" rating. But the fine print disclosed that the report was part of an "investor awareness program" paid for by a Universal Bioenergy shareholder.

Look what happened to the price of the stock: On December 1, when only 200 shares were traded, Universal Bioenergy closed at 13 cents a share. By January 27, the price reached $1.80 a share and 572,000 shares changed hands. On the same day, Bioenergy issued a press release disavowing the accuracy of the information disseminated by third parties and advising potential investors to check its filings with the Securities and Exchange Commission. (The filings show the company has no revenues or earnings.) On January 28, 712,000 shares were traded and the stock closed at 69 cents a share. On May 14, 22,000 shares were traded and Universal Bioenergy closed at 4 cents.

Our efforts to contact Universal Bioenergy were unsuccessful; in our final attempt, a recording said the firm's phone number had been temporarily disconnected. Joseph Borg, director of the Alabama Securities Commission, told us that regulators have no jurisdiction over mailings such as the Clean Energy Review if it's noted that the material is a paid promotion. "Sending out an ad like that is not against the law," he says.

It can be difficult for investors to differentiate between the tiny companies that are worthwhile investments from those that could be easily manipulated. If you're determined to buy individual small stocks, avoid anything touted on the phone, on the Internet and by direct mail. Make sure that research reports are not sponsored by interested parties.

Stick to companies listed on major exchanges, such as the New York Stock Exchange and Nasdaq. Avoid stocks traded on over-the-counter markets, such as Pink Sheets or the OTC Bulletin Board. On these systems, listing requirements, such as trading volume and company assets, are minimal. Also, stocks that are included in indexes like the Russell 2000 and Standard & Poor's SmallCap 600 usually have more trading volume and analyst coverage.

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Joseph Lisanti is a former editor-in-chief of Standard & Poor's weekly investment advisory newsletter, The Outlook. His writing has also appeared in BusinessWeek Online, the Los Angeles Times, the New York Daily News, Financial Planning, and Variety.