“My friend told me about this mining stock that will spike from $0.001 to $5 over the next 6 months.” WOW, this is a great investment right?…wrong. Almost everyday someone calls me to talk about some hot penny stock that they know is going to take off. They got this “tip” from some co-worker that knows nothing about stocks or a random email from an unknown sender. When I hear about this guaranteed, get rich quick investment, alarm bells start ringing in my head. I don’t come right out and tell people that the stock they have their heart set on is a complete piece of crap. I approach the situation in a more tactful manner and ask questions that in the end, should make the investor realize on his or her own, that the stock is junk. If I can’t stop you from messing with penny stocks, at least I can tell you what to look for before you jump in.
Number one, know the name of the company. It kills me how many people want to put their hard earned money into a stock and they don’t even know the name of the company. Are you kidding me? Most of the time we’re talking about thousands of dollars of your hard earned money. It may not seem important to know of the name of the stock you’re buying, but trust me it is.
Next, do some additional research apart from the newsletter you read. Anybody who has an account with a brokerage firm will have access to free research. If you do not, that’s a entirely different issue that just gave me the idea for a future post. The most important document you can look at is the 10-K – the annual report. Tucked within this document are some obvious clues to look for.
Towards the beginning of the 10-K, you will find a section titled “Our Current Business”. This summarizes what they do, their assets, cash flow, etc. For the purpose of this post, I’m going to pick on a mining stock. However, I’ve seen the same type of business practices in the pharmaceutical, agriculture and many other industries. Phrases that you’re looking for look exactly like this:
“The Company was organized for the purpose of acquiring, exploring and developing mineral properties. The Company has not established the existence of a commercially minable ore deposit and as at the fiscal year end has not reached the exploration stage and is considered to be in the pre-exploration stage.”
It’s entirely normal for a company to be engaged in development activities with no commercial outputs, but this is NOT something you want to invest in. Nine times out of ten, the only thing this company will develop is losses for you.
We’ll find the next red flag towards the middle of the document – search for “Going Concern”. Although I shouldn’t, it’s painfully hard not to laugh each time I read this section. Sometimes it will flat out state that if this company does not secure future infusions of cash, it simply won’t be able to exist in its current state. Basically, the company is surviving by borrowing money or selling additional stock to raise capital. How long could you survive by borrowing funds to pay your bills? Not very long if you don’t have a stream of cash flow. This is taken from the same mining company K-10 as the excerpt above:
“In their audit report relating to our financial statements, our independent accountants indicated that there is substantial doubt about our ability to continue as a going concern. Such factors identified in the report are our lack of working capital for operations and to service our debt. These factors continue to exist and raise doubt about our status as a going concern.
We anticipate that additional funding will be required in the form of equity financing from the sale of our common stock or by way of debt. At this time, we cannot provide investors with any assurance that we will be able to raise sufficient funding from the sale of our common stock or through a loan from our directors or unrelated parties to meet our obligations over the next twelve months. We do not have any arrangements in place for any future debt or equity financing.”
Lastly, take a look at the company’s income statement. If the other sections don’t make it glaringly obvious that the company is or is not investment worthy, find out how much they make and the rate at which their numbers are growing. You can evaluate the year over year and the quarterly numbers. If the above statements are found in the K-10, I guarantee that the company is bleeding cash.
Hopefully after reading this, I’ve prevented you from wasting your hard earned money or at least you realize that you’re playing the stock market lottery. In the case of the latter, you now know what the risks are so you can make a more informed decision. To avoid making this post too long, I will discuss the manipulative “Pump and Dump”scheme in detail in the future. It’s because of this scheme that you’ve probably heard about this stock in the first place.
Who has had luck investing in penny stocks? Any big winners out there?
[Featured image credit http://dribbble.com/CurtisJinkins] [2nd image credit http://dribbble.com/markmccoy]
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