There’s no question about it – penny stocks can bring home some of the biggest gains in the investment world. But those tiny companies can also bring along quite a bit of risk. In fact, one of the biggest questions we get here at Penny Sleuth HQ is: “Can you tell me if XYZ Corp. is legit?” And while we can’t give out personalized investment advice, we can give you the tools to determine whether you’re investing in a business with serious profit potential or a scamster’s shell game…

Here’s how to know if your next penny stock play is legit…

For many investors, the idea that a stock could be representing itself incorrectly is unthinkable. After all, we’ve got the SEC, the exchanges – like NYSE and NASDAQ – and independent auditors taking a look at every filing that a company puts out to shareholders. But in the world of microcap stocks, many of those same protections just aren’t there.

While Securities and Exchange Commission (SEC) was created, in part, to protect investors from nefarious activities in the stock market, the countless securities scandals of the last couple of years have shown us that the agency simply doesn’t have the resources to make sure that the smallest companies are reporting accurately. And in fact, many of the smallest microcap stocks are completely exempt from reporting to the SEC.

Serious listing requirements (almost always) ensure that stocks trading on major exchanges are legitimate businesses, but for stocks that trade OTC or on the Pink Sheets, the requirements to get shares trading are slim to none.

And while most investors think of audited financials as a safeguard that keeps a company’s financials accurate, many companies also aren’t required to get their books audited because of their size.

Even if you’re thinking about investing in a Pink Sheets stock that’s exempt from registering with the SEC and getting an audit performed, you might still be looking at a perfectly good penny stock investment… but you have to do your homework.

Verify the Business

The first step to determining whether a penny stock is legitimate is to verify that the business exists and does what you think it does.

You can start off by entering the stock’s ticker on a major financial site – like Google Finance – and checking out the description of the company. Those descriptions come from SEC filings, so you can generally trust what they say since thanks to the Sarbanes-Oxley Act, it’s a felony for management to lie on company filings.

Also, log onto the SEC’s website and look for company filings to get the full look at a company’s operations. And don’t forget to look at its ticker… an “E” at the end means that the company is delinquent in providing its regulatory filings – a very big red flag.

For companies small enough to not file with the SEC, ask your broker for a copy of the company’s “Rule 15c2-11 file”. In it, you’ll find a slew of information that the company was required to provide to prove their exempt status.

Check the Auditor

When you’re reading a company’s financials on the SEC website, look for the audit opinion (generally near the end of a 10-K annual report filing). It’s a statement from the independent auditors that explains the steps an auditor took to verify a company’s financials as well as whether the financials are accurate in their opinion.

Checking who the auditor is makes a big difference too. Bernie Madoff’s “independent” auditor was neither – he trusted Madoff too, blindly signing off on the scamster’s financials and losing millions of his own in the process. Checking into the accountant’s CPA firm would have showed that it was a tiny storefront with only one CPA and without the manpower to audit a multi-billion dollar financial firm.

Getting audited by one of the “big four” accounting firms – PricewaterhouseCoopers, Deloitte, KPMG, and Ernst & Young – is generally the domain of big blue chips that can afford to have prestigious accounting firms handle the audit, so don’t stress if the auditor’s name doesn’t look familiar. Take the time to research who the auditor is, though, and whether they’re qualified to handle a company audit. A quick Google search should solve that…

Give Them a Call

Hard-to-find contact information is another red flag that should be watched out for. Since most companies are constantly on the lookout for new business, their sales team should at least be easily accessible. If you have concerns about whether or not the company is legit, go ahead and call the phone number on their website. If you can’t find a number or address, check back on the SEC website – companies have to include their corporate contact information on the cover of all 10-K and 10-Q filings.

New technology has also made it much easier to verify a business’s contact information. Just type in a company’s address into Google Maps, and select “Street View”, and you can actually see the building where its offices are located. If the offices for a publicly traded stock are showing up as someone’s home or a mailbox rental store, be very wary of going forward.

Follow the Money

If you really want to know about a company, you have to follow the money – its customers…

For any company that markets its products to consumers, a quick web search should give you an idea of how well – or poorly – the company is treating the people who use its services. Reading customer experiences will also give you an idea of whether or not people are jibing with the company’s offerings.

Googling your way to customer experiences isn’t always an option, especially when a company caters to enterprise or government clients. In these cases, where more money is generally involved, lawsuits are more likely as a result of business disputes. Check an online legal database – like the U.S. PACER System – to see whether your potential microcap investment is being sued by customers.

Check for Promotions

It’s possible for a company to be legitimate while the news that “independent parties” are touting isn’t. These so called “stock promoters” are publishing faux research reports and stock recommendations in hopes that investors will catch on to the penny stocks they’re selling. They do this through websites and newsletters that seem legitimate on the surface, but are essentially nothing more than schemes to get people to buy these stocks.

While we’ve never accepted money to write about any stock here at the Sleuth, some in the industry do… And believe it or not, it’s completely legal as far as the SEC is concerned.

There are a few ways that you can tell whether a stock’s being pumped by a promoter. For starters, go to the horse’s mouth – check out StockPromoters.com – the site features a listing of which stocks are paying for which promoters, as well as what the promoters are getting in return.

Promoters aren’t ashamed about what they do – they want companies to know how good they are at their jobs…that’s why they’re so easy to spot.

More Homework, More Profits

To be sure, doing the research is tough and time consuming. But it’s also the only way to be completely sure that the next penny stock play you’re putting your hard earned money on the line for is legit. Small stocks have some of the greatest gain potential out there – and if you know what to look for, you can make sure that you don’t get burned in the process of pursuing profits.

Cheers,
Jonas Elmerraji

November 5, 2009

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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