The Perils of Penny Stocks

Paul Allen understands all too well the pitfalls of purchasing penny stocks. Last spring, Allen, a 65-year-old retiree from Boston, invested in Vapor Hub International (symbol VHUB) after receiving a flood of e-mails suggesting that shares of the e-cigarette company were about to take off. He quickly lost 80% of his investment.

Allen won’t be the last investor to suffer such a fate. The possibility that a stock will soar from a few pennies a share to a few dollars, or more, is too tempting to ignore, even if the potential for fraud is great.

Consider how investors got sucked into a company called Cynk Technology (CYNK). Cynk, which had no revenues and just one employee, briefly enjoyed a market value of more than $6 billion, thanks to a promotional blitz that started in June and sent the shares soaring from 6 cents to nearly $22 in just a few weeks. The Securities and Exchange Commission ended the party by suspending trading in the stock on July 11. When the SEC lifted the suspension on July 25, the stock sank 96% in two days.

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Encouraged by a bull market and the exorbitant prices companies are paying to buy start-ups, more and more people are hoping to make a killing with penny stocks. According to OTC Markets Group, where many tiny companies trade, some $26 billion in penny stock shares changed hands in 2013, up 46% from the previous year’s volume.

The apparent manipulation of Vapor Hub’s stock was typical. Vapor Hub operates two retail shops in the Los Angeles suburbs where you can try different e-cigarette flavors. According to its March 31 financial statements, the company lost $6,048 in its first nine months of operation. And its survival depends on its ability to raise more capital—a prospect so uncertain the firm said its ability to stay in business was in doubt.

But in April, two newsletters, Analysts Review and Investor-Edge, received $65,000 to promote Vapor Hub and began sending out rapid-fire e-mails about their top pick in the e-cigarette sector. The shares doubled in a matter of days, convincing Allen he needed to act fast. The stock, which hit 87 cents in early April, closed at 11 cents on July 31.

Fraud risk. The SEC, which defines penny stocks as those that trade for less than $5 per share, says this market is unusually vulnerable to fraud for a variety of reasons: Few seasoned analysts follow penny stocks, financial information is scarce, and many supposedly unbiased reports are actually written by paid promoters. The SEC doesn’t list enforcement actions based on market capitalization, but the agency has shut down hundreds of suspicious stocks in the past year.

Of course, plenty of legitimate outfits with tiny share prices—so-called micro caps—eventually grow into bigger concerns and reward shareholders. On average, about 50 firms graduate to larger exchanges each year, says Cromwell Coulson, CEO of OTC Markets Group. He says his exchange tries to curb fraud by making financial information more readily available and by adding a skull-and-crossbones warning to a company’s listing when the exchange learns that the stock is the subject of an e-mail campaign.

But the warnings often come too late for individual investors such as Allen. The best way to avoid penny stock scams is to do independent research, says Ken Springer, a former FBI agent who conducts investigations for institutional investors.

Start by visiting the SEC’s Web site. Look at a company’s 10-K annual report, 10-Q quarterly reports and Form 8-K filings, in which companies report “material” events. Checking out promoters can be tougher, but some telltale signs are readily available. For example, disclosures on the Web sites of Investor-Edge and Analysts Review revealed that they had received payments from Vapor Hub. Says Allen: “I’ve been torturing myself over this. It’s not that I didn’t know the right questions to ask. It’s that I invested before I asked the questions.”