Avoid Reverse Stock Splits

When we are looking for a penny stock to invest in we have a list of criteria to follow, one of them is to avoid stocks that have recently undergone a reverse stock split or are planning on doing a reverse stock split. There are a number of reasons why a company conducts a reverse stock split, such as: attract more institutional investors, reduce expenses by "shaking out" the individual investor and to avoid de-listing. The latter, being the most common reason.

There have been numerous studies conducted on reverse stock splits and with stock that trade on the OTCBB and NASDAQ there is an overwhelming negative price impact. To learn more about reverse stock splits, click here.

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Recap of Recommendations from December 2005

We are very proud to announce that our picks from 2005 were outstanding by anyone’s standard. The one thing that sticks out to us is that we managed to have this track record by picking stocks in many different sectors. Listed below are two oil stocks, they are: Tengasco Inc. and Clickable Enterprises. We also recommended Linux Gold Corp and gold mining company. We also recommended Breakwater Resources Ltd. natural resource company that mines zinc and copper. Lastly, we recommended the internet service provider SiteStar Corp. Please click on the links to see our original recommendation and why we made the recommendations.

Date Purchased	Symbol	Purchase Price	Current Price	% Gain	High Price	High Price % Increase
12/1/2005	TGC	$0.42	$0.75	78.57%	$0.74	123.80%
12/7/2005	CKEI	$0.022	$0.036	63.63%	$0.07	218.18%
12/14/2005	LNXGF	$0.24	$0.40	66.66%	$0.55	129.16%
12/21/2005	BWLRF	$0.47	$0.88	87.23%	$1.08	129.78%
12/29/2005	SYTE	$0.055	$0.071	29.09%	$0.08	45.65%
TOTAL GAIN				65.03%		129.31%

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Disclaimer: We have NOT been compensated in any form by the companies above or any third parties representing them. Additionally, we do NOT own shares in any of the stocks above. We are a completely non-biased service.

We Were Interviewed on Fundadvice!

The founder and President of The MicroCap Speculator, Jim Murray, was interviewed on the radio show, Sound Investing (Fundadvice.com) with Paul Merriman. Please tune in and give it a listen as Jim shares his passion for penny stocks. Our interview is approximately 29 minutes into the program.

Click here for the interview!

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How Do You Successfully Invest in Penny Stocks?

Hey, I have a hot stock tip for you…It is a can’t miss, it is in energy and everyone is always looking to lower their monthly utility bill, especially with the high cost of oil. The company has $8 million in assets and for the last nine months the company has earned $2.7 million in revenue. They are a generator and wholesaler of electric power to electric utilities serving the retail electric market. The Company currently owns and operates a 38-megawatt co-generation facility in North Carolina, which has governmental permits to burn a variety of fuels. They are also an established company and have operated since 1986. The best part, the stock only costs $0.03 per share. Call your broker and get on this one quick before it doubles or triples and you lose out!”

We have all heard or received e-mails like the scenario above and unfortunately many of us have purchased stocks on a flier or trusted what was being sent to us or told to us – only to lose our money. The scenario above is a real company, however if you conducted due diligence on them you would learn that they are losing $0.21 per share, have defaulted on a bank loan and are late filing financial documents with the SEC. Clearly, a stock one should not be purchasing. However, not all penny stocks are like the scenario above, many are good, small companies that are profitable and looking to attract investors – the trick is to find them. In this article, I hope to educate you on the steps you can take to reduce your risk when investing in penny stocks.

The first question that needs to be answered is…what is a penny stock? On the surface it appears to be a simple question, with a simple answer…stocks that trade for a penny. However, there is not a definition that is adhered to by all. The Securities and Exchange Commission (SEC), in April 1992, defined penny stocks as shares of any company that trades for less than $5. This would make, such well-known stocks as Sun Microsystems, JDS Uniphase, Nortel, Lucent and Sirrus Satellite Radio all penny stocks, since they all trade below $5, even though all have a market capitalization in the billions! Additionally, the definition includes any stock that is not traded on a national securities exchange or quoted in the NASDAQ list maintained by the National Association of Securities Dealers (NASD). By this definition, companies such as Nestle, which trades at $57 per share, would be considered a penny stock, because it trades on the pink sheets as an American Depository Receipt (ADR). Furthermore, when the SEC discusses microcap stocks, a term often used interchangeably with penny stocks, it isn’t much clearer. It states that the term "microcap stock" applies to companies with low capitalization, meaning the total value of the company's stock. Microcap companies typically have limited assets. For example, in cases where the SEC suspended trading in microcap stocks, the average company had only $6 million in net tangible assets — and nearly half had less than $1.25 million. Microcap stocks tend to be low priced and trade in low volumes. Again, it there is no accepted definition, for this article we will define a penny stock as any stock that trades under $1, regardless of market capitalization on any exchange (e.g., NYSE, AMEX, NASDAQ, OTCBB and the pink sheets.

There are a number of reasons why individuals invest in penny stocks; many like myself do it as a hobby, there are others that allocate a small percentage of their portfolio to invest in penny stocks and there are those that do it in the hopes of getting rich. If you fall into the latter category, you are probably better off going to your local horse track and put all your money on the horse with the jockey whose is wearing red silks, you have a better chance of getting rich doing that. Penny stocks are inherently high-risk propositions, so be wary of penny stocks. The chances of huge profits are outweighed by even larger chances of losing all of your money.

Once you have decided to invest or trade in penny stocks the fist step in your due diligence process should be to determine what exchange the stock is being traded on. Using a very broad definition, penny stocks can be put into two categories, they are: small/new/growing companies, such as Firearms Training Systems (OTCBB: FATS) and well-established companies on their way down. The most notorious example of a high profile company on its way down is Enron, which amazingly still trades at $0.04 per share on the pink sheets. There are many examples of companies that trade on the NYSE and the NASDAQ whose stock trades at or below a $1.00, these companies should be avoided like the plague, as they are companies in deep trouble. The NYSE and NASDAQ both have requirements regarding stock price, therefore companies trading at those levels, on those exchanges are on the verge of being de-listed. There are two other venues, in the United States, where penny stocks are traded; they are the Over the Counter Bulletin Board (OTCBB) and the “pinksheets”. The main difference between the OTCBB (www.otcbb.com) and the pinksheets is as of July 2000 all OTCBB stocks are required to file financial reports (e.g., quarterly and annual reports) with the SEC. Pinksheets (www.pinksheets.com), called that because of the color of paper the quotes are printed on, are like the Wild West; these companies are NOT required to file with the SEC, although many of them do. There are a variety of companies listed on the pinksheets; there is everything from Mom and Pop operations to large foreign companies that have American Depository Receipts (ADR’s) listed. Since, companies are not required to file documents with the SEC on the pinksheets it becomes extremely difficult to obtain information regarding the financials of the company and when you do find information, you should question there accuracy. Since companies are required to file financial documents on the OTCBB, it is recommended that your penny stock picks be limited to those listings.

TIP: Find a stock that is traded on the OTCBB.

Step two on your due diligence checklist should be: What is the company’s ticker symbol? Stocks that are traded on the OTCBB usually have four characters; however many times you will notice stocks with a fifth character in their symbol (see chart below). Symbols with five characters are not an inherently bad thing, however, there are a two fifth character symbols that should be major red flags when selecting a stock, and they are the symbols E and Q. A ticker symbol with a fifth character of “E” (e.g. WXYZE) indicates the company is late filing their required reports with the Securities and Exchange Commission (SEC). This should tell you the company is run poorly, as filing with the SEC is important and should be a priority if the company is serious about attracting investors. Additionally, there is a good likelihood the company is experiencing financial problems. It should be noted that once the company files the required documents the E is dropped from the stock symbol. The other symbol that is a major red flag is Q. Any company with a fifth character of a Q in their symbol (e.g., WXYZQ) is in bankruptcy. While there are examples of companies emerging from bankruptcy and the stock doing well, it isn’t normally the case. Take a look at many of the dot com stocks that ended up going bankrupt. Many didn’t emerge or their stock became worthless.

TIP: Don’t invest in companies whose symbol ends in E or Q.

Now you have determined that the stock is traded on the OTCBB, is current with their financial statements and not in bankruptcy – a good start. It is now time to start delving into the nuts and bolts of the company. The best way to do this is to start reading the latest quarterly report. You can find quarterly reports via Yahoo! Finance on Edgar-Online.com. Your first stop in the report should be to determine if the company has a “going concern” statement in their report. An independant auditor that basically states there are reasons to believe that the company is not going to be able to maintain itself as a viable business writes a going concern statement. It will read like: “The report of independent auditors on the Company's December 31, 2003 consolidated financial statements includes an explanatory paragraph indicating there is substantial doubt about the Company's ability to continue as a going concern.”

TIP: Don’t invest in companies who have a going concern clause in their financial statements.

So, you have determined that they aren’t going to close their doors in the next few days; the next step is to start figuring out what the company does. My recommendation is to stick to companies you understand. For example, when I read quarterly reports of pharmaceutical and genetic stocks, they make no sense to me because I don’t understand the science of the company to know if what I am reading is good, bad or indifferent, so I never invest in those companies. In the annual or quarterly report you should read the profile of the company. This is management’s description of what the company does, its mission, what products they sell or service and what subsidiaries they have. This type of information is normally listed in the Managements’ Discussion of Operations. When reading the profile keep in mind that most successful companies focus on one type of business, such as PC’s, clothing retail, wireless access, etc. However, it is common in penny stocks to find companies that have revenue streams from two or more, very different sources. For example, the company Ad South Partners (OTCBB: ADPR) is the combination of beauty products company and an advertising agency. Their primary revenue stream is an advertising agency; however they also market various facial and skin creams. While both may be a good idea and be profitable, rarely does an entire management team have expertise in advertising and beauty products.

TIP: Look for a company that does one thing and does it well.
TIP: Stick with companies whose business practice you understand.

The next topic is the subject of books, however for this article we are going to condense the financial statements down to looking at one number, earnings per share. With any stock, not just penny stocks the purpose of being in business is to make money, so try to invest/trade in companies that are profitable. There are many financial stock screeners on the Internet that can be used to find profitable penny stocks. There is a good one on www.smallcapcenter.com

TIP: Pick a company that is profitable, there are plenty of profitable penny stocks.

A valuable source of information regarding companies are the news stories and press releases that are sent out. Take a look at Yahoo! or smallcapcenter.com to get a list of the recent news releases, read them all. In doing so, you will start to get a sense if the company is flourishing or if the company is struggling. Press releases also keep the stock on the “radar scope” of many investors. Also, look out for any red flags, such as the SEC sending a formal order to conduct an investigation on the company. While not a penny stock, a good example of the carnage that occurs when the SEC comes knocking on the door is Krispy Kreme doughnuts. The stock lost approximately 40% of its value once the SEC investigation became public information. TIP: Pick a company that generates some press, it is likely to have more trading activity.

TIP: Don’t invest/trade in a stock that is being investigated by the SEC.

When reading the Company’s news releases and their SEC filings, be wary of companies that have approved reverse stock splits. Companies generally conduct a reverse split to increase the share price to make the equity more appealing to investors and institutions. An example of a 1:10 reverse stock split would be if you owned 1000 shares of a $0.50 stock, you would need to trade in all 1000 and would get 100 shares in exchange that would now be worth $5 each. While there are legitimate reasons to conduct a forward split (e.g., get rid of small shareholders that are an administrative expense), but normally it is an act to artificially pump up the price of a stock whose share price is low.

TIP: Don’t invest/trade in a company that is planning to conduct a reverse stock split.

Many penny stock companies hire investor relation firms to recommend the company stock to various media avenues. So, very often if you search the Internet for a particular company you will stumble upon a research/recommendation report written by an investor relations firm (samples can be found on ceocast.com, under the research tab). While many of these reports do provide excellent information, their recommendation must be taken lightly. Generally, these companies receive large amounts of shares in exchange for the research report. Companies are required by law to disclose if they received shares. This information can be found in the disclaimer at the end of the research report. An example is:

“The Buy our Stock Service is a registered investment advisor that produces equity research reports. On September 24, 2004, in consideration for Buy our Stock Service equity research services, including this report, the Company agreed to pay Buy or Stock Service a fee of 500,000 shares of the Company's common stock.”

Obviously, if you see a disclaimer like the one above you need to concern yourself with how objective the report really is. Again, this is why doing your own due diligence is key.

TIP: Be extremely wary of research reports when the firm was paid either in cash or stock.

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