By Ross Brayton, Scottrade Branch Manager, Cape Coral, Fla.
Over the course of our investing experiences most, if not all of us, have pondered the idea of investing in low-priced or “penny” stocks. The possibility of picking the stock that could quickly double or triple in value can be quite an intoxicating thought. While some perceive a lack of worth in penny stock investments, to simply generalize that every penny stock is not worthy of investment would not be appropriate.
Seeing the Big Picture
For starters, with so many small companies going unnoticed, it is possible to uncover a few hidden gems with just a little research. Management of these small companies is typically more accessible and willing to have detailed discussions with individual investors. Additionally, company filings are often not as complicated to read and understand.
That is not to say that investing in penny stocks is without elevated risk. Most micro and small capitalization companies are typically not covered by analysts, leaving you to do your own research. With a lack of available public information and management that might act as a company cheerleader, finding reliable sources of information can be quite difficult. Beyond those issues, many of these companies are “development stage companies”, meaning they require capital from new shareholders as they develop sales channels, products and explore market opportunities. In order to raise capital, they may even hire firms to offer coverage on their shares, but those reports may have an inherent bias based on the nature of the analytical firm’s compensation.
Doing Your Due Diligence
In a 2006 study that is to date their most recent analysis, the Bureau of Labor Statics estimates that as many as 62% of businesses fail within the first five years. The same can hold true for businesses with publicly traded stock, making those start-up companies a potentially risky investment. In order to combat those odds, consider becoming familiar with the resources available to you.
First consider looking into filings with the Securities and Exchange Commission (SEC). Forms 10-K and 10-Q are the annual and quarterly reports which highlight business risks, the company’s financial position and management’s discussion of material events at the company. These filings are highly useful for the purpose of debunking penny stock investor newsletters and overly optimistic press releases issued by management.
To gauge the investor friendliness of management, consider looking at the section titled “related transactions”, which discloses transactions between the company and individuals with direct ties to management. If the company executives are entering into agreements that favor friends, family and management more than shareholders, it might offer a hint as to the quality of the investment.
If information is not available from the SEC, you can also seek information from local and government regulators where the company is incorporated. One tip before doing so is to investigate news articles and the company Web site to look at the company’s history. Often, small publicly traded companies change names and business direction. In doing so, all the filings are still listed under the original parent company’s name, making the research process a little more difficult. The company Web site, if available, may have links within the investor relations sections that direct you to the company’s required filings and audited financials. Finding unaudited financial statements on the company’s Web site is a good idea, but keep in mind that other information you read there was produced by the company and is unlikely to be objective.
Thinking it Through
A famous investor named Benjamin Graham once said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.” His point was that all too often investors base their decisions on hope, fear, speculation or greed and less often on facts. So while the idea of “loading up” for the hopeful home run on the surface may seem to make sense, when thought through in a business-like manner, the facts may not support the conclusion. It helps to use your resources, and while you can be hopeful for a positive outcome, keep a critical eye on management and your sources of company information.
The material provided in this presentation is for informational purposes only and its use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision. Market volatility, volume, and system availability may impact account access and trade execution.
