Why Do Penny Stocks Fail?

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[Kendi]

Lack of Information Available to the Public

It's important with any successful investment strategy to have enough information to make an informed decision. For penny stocks, information is much more difficult to find as compared to well-established companies. Also, information available about penny stocks may not come from credible sources.

Stocks traded on the OTCBB carry the "OB" suffix to their symbol. These companies file financial statements with the SEC. However, companies listed on the pink sheets are not required to file with the SEC. As such these businesses do not receive the same public scrutiny or regulated as the stocks represented on the NYSE, the NASDAQ, and other markets.

No Minimum Standards

Stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain on the exchange. Once a company can no longer maintain its listing position on one of the major exchanges, the company can move to one of the smaller OTC listing exchanges. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.

Lack of History

Many of the companies considered to be penny stocks could be newly formed, and some could be approaching bankruptcy. These companies will generally have poor track records or no track record at all. As you can imagine, this lack of historical information makes it difficult to determine a stock's potential.

Liquidity and Fraud

Stocks that trade infrequently do not have much liquidity. As a result, it is possible that investors won't be able to sell the stock once it is acquired. The investors might need to lower their price until it is considered attractive to another buyer.

Low liquidity levels also provide opportunities for some traders to manipulate stock prices. The pump and dump scheme is a popular trading scam to lure investors into buying a stock. Large amounts of a penny stock are purchased followed by a period when the stock is hyped up or pumped up. Once other investors rush to buy the stock, the scammers sell or dump their shares. Once the market realizes there was no fundamental reason for the stock to rise, investors rush to sell and take on losses.

Advantages

·         Offer a place for small companies to gain access public funding.

·         In some few cases, penny stocks may provide a method to gain access to larger marketplace listing.

·         With a lower price, penny stocks allow for significant upside in share appreciation.

Disadvantages

·         Penny stocks lack a liquid market with few buyers, perhaps even after their price has increased.

·         There is limited information available on the company's financial soundness or track record.

·         Penny stocks have a high probability of fraud and bankruptcy of the underlying company.

 

 

Signs of Fraud

Though there is no fool-proof safeguard with penny stocks, the SEC recommends that investors look out for the following warning signs: SEC trading suspensions, spam, large assets but small revenues, financial statements containing unusual items in the footnotes, odd auditing issues, and large insider ownership.

Real World Example of Penny Stock Fraud

California resident Zirk de Maison created nearly half of a dozen shell companies and offered them as penny stocks to investors between 2008 and 2013, according to the Federal Bureau of Investigation (FBI). De Maison told investors that the companies engaged in a variety of businesses, such as gold mining and diamond trading when, in fact, they did nothing. He sold the stocks through "boiler rooms," offices where brokers use high-pressure tactics to push people into buying stocks by promising large profits, embezzling $39 million. In 2015, de Maison and seven other perpetrators were found guilty of securities fraud and sentenced to federal prison. 

 

 

How Is a Penny Stock Created?

Small companies and startups typically issue stock as a means of raising capital to grow the business. Though the process is lengthy, issuing stock is often one of the quickest and most effective ways for a startup company to obtain capital.

A penny stock, like any other publicly traded stock, is created through a process called an initial public offering or IPO. To be listed on the OTCBB the company must first file a registration statement with the SEC or file stating the offering qualifies for an exemption from registration. It must also check state securities laws in the locations it plans to sell the stock. Once approved, the company may begin the process of soliciting orders from investors. Finally, the company can apply to have the stock listed on a larger exchange, or it can trade on the over-the-counter market, or OTC.

Underwriting Penny Stock

As with other new offerings, the first step is hiring an underwriter, usually an attorney or investment bank specializing in securities offerings. The company's offering either needs to be registered with the SEC according to Regulation A of the Securities Act of 1933 or file under Regulation D if exempt. If the company is required to register, Form 1-A, the registration statement, must be filed with the SEC along with the company's financial statements and proposed sales materials.

The financial statements need to remain available to the public for review, and timely reports must be filed with the SEC to maintain the public offering. Once approved by the SEC, orders for shares may be solicited from the public by accompanying sales materials and disclosures, such as a prospectus.

Trading Penny Stocks

After initial orders are collected and the stock is sold to investors, a registered offering can begin trading in the secondary market via listing on an exchange like the NYSE, NASDAQ, or trade over-the-counter. Many penny stocks wind up trading via OTC due to the strict requirements for listing on the larger exchanges.

Sometimes companies make an additional secondary market offering after the IPO, which dilutes the existing shares but gives the company access to more investors and increased capital. Furthermore, it is mandatory that the companies continue to publicly provide updated financial statements to keep investors informed and maintain the ability for quoting on the Over-the-Counter Bulletin