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Get wise to penny stocks
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July 27, 1999: 6:22 a.m. ET
These low-priced shares require some scrutiny, but they may fill your pockets
By Staff Writer Nicole Jacoby
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NEW YORK (CNNfn) - A wave of Internet scams and fraud investigations has left penny stocks with a tarnished image, but some investment strategists say these low-cost shares don't deserve the bad rap.
"It has been somewhat of a sport to bash the pennies," George Schlieben, publisher of the Global Penny Stocks newsletter, said. "But these stocks aren't as segregated or scorned as they were maybe ten or fifteen years ago."
While penny stocks are more susceptible to legal misdeeds than their larger, more established counterparts, many of these issues see respectable gains without incident each year.
But penny stocks aren't for everyone. To achieve the lustrous returns promised by impassioned penny-stock strategists, you'll have to arm yourself with information and stay on your toes.
Learning the basics
Penny stocks are defined by the Securities and Exchange Commission as shares that trade for under $5 apiece. They are sometimes confused with micro caps. While the two terms are at times used interchangeably, the bases for their definitions are somewhat different. Whereas penny stocks are defined by their share price, micro caps are categorized according to their market capitalization.
The two can share some characteristics. Both typically have low market capitalization and limited assets. But penny stocks are less likely than micro caps to be listed on a major exchange and are commonly traded over the counter with quotes listed on bulletin boards or so-called "pink sheets," which are distributed weekly by the National Quotation Bureau.
The problems often associated with penny stocks stem primarily from the lack of available information regarding these issues. Companies that trade their shares on major exchanges and on the Nasdaq, for instance, must meet minimum listing standards, such as a set number of assets or shareholders. Companies trading over the counter or on pink sheets do not have to meet any of these requirements.
And unlike larger companies, companies with less than $10 million in assets are not required to file reports with the SEC. While the SEC has tried to mitigate this problem by establishing additional reporting requirements for penny stocks, some companies have gotten around this by initiating reverse stock splits to bolster their value above $5.
While larger public companies are regularly researched and tracked by stock analysts, penny-stock companies have traditionally been largely ignored by the mainstream investment community.
Another problem associated with penny stocks is "pump and dump" schemes. Many unscrupulous brokers artificially inflate a stock price by promoting it to their clients. After the stock soars, these brokers effectively "dump" their shares, making a hefty personal profit.
Penny stocks are particularly susceptible to such manipulation because with lower share prices, large blocks of stocks can be bought and sold more easily.
Risks and rewards
Despite these risks, an investment in penny stocks can be rewarding.
"There are always a few bad apples," said Duncan King, a spokesman for the SEC. But "a lot of these small companies correctly and wisely use these markets to raise capital, create jobs and help make early investors better off."
A group of penny stocks tracked by the newsletter Global Penny Stocks, for instance, experienced a 53 percent gain over the past 2-1/2 years. But there have been some letdowns. Several shares saw a loss of between 15 and 100 percent.
"Some of the stocks have been bombs, but that's the nature of the game," Schlieben said, who recommends investors not put more than 15 percent of their portfolios in penny stocks.
"Don't bet the house, just bet the downstairs bathroom," he said.
Separating good pennies from bad
Weeding out the good seeds from the bad is the key to success in the penny-stock arena.
But the rise of the Internet, along with the bull market, has made the task somewhat more difficult, as investors inundated with market information sometimes see their sensibilities blinded by dazzling Wall Street gains.
"Unfortunately, there is no 'sort' button on the Internet," King said. "Investors need to take the information they get off the Internet with a grain of salt."
The reality is penny stocks often are issued by new companies with no proven track record. And sometimes they have no assets or operations and have products or services that are still in development or have yet to be market-tested.
"If you look at the universe of the 7,000 or so stocks that are priced this way, most of them you wouldn't want to touch," said Harry Eisenberg, author of "Walker's Manual of Penny Stocks." "But many of them are fine."
Many young, struggling companies can be good investments in the long run precisely because institutional investors avoid them, Eisenberg says.
"Any area where institutions are not involved is great for individuals," Eisenberg said. "When the institutions aren't involved, the price is less conditioned on market movements and more based on the company's fundamentals."
Investment strategies
To find hidden value among penny stocks, start off with a company's financial statement.
"If they have not issued a financial statement, that's a company to stay away from," Eisenberg said. "You can't do any evaluation without looking at assets and revenues."
Upon assessing the statement, find out if the company has working capital. Does its current assets exceed its liabilities? What is the ratio of debt to equity? Are the company's revenue and profit growing?
"These few factors will keep most people out of trouble and allow them to look at many exciting opportunities," Eisenberg said.
And don't fall prey to rumors and stereotypes. Just because a stock is not listed on a major exchange, for instance, does not mean it is a bad investment, says Eisenberg.
Protecting against scams
Finally, steer clear of penny-stock-related scams by watching out for these red flags:
 Beware of brokers with high-pressure sales tactics, promising "once-in-a-lifetime" opportunities or "insider" information.
Think twice before investing in a company that has been the target of an SEC trading suspension.
Watch for odd footnotes in financial statements. They might reflect unusual loans or the exchange of questionable assets for company stock.
Take note of unusual auditing issues, such as auditors who refuse to certify the company's financial statement. Also question any change of accountants. 
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