The stock market can be a wonderful place that allows millions of people to invest in some of the worlds biggest companies. Individuals are able to share in the profits of thriving businesses that they believe will continue to succeed in the future.
Sadly, like many other parts of life, particularly those where money is involved, there are those who will attempt to scam you by posing as something they are not. This is especially prevalent in very-small stocks, so-called penny stocks, or micro-cap stocks, are often small companies that offer big opportunity, but it can often be hard to tell the difference between a small company with a lot of potential, and scam company telling a good story.
So, what should you look out for in order to avoid putting your own money into an illegitimate business?
MarketingOne of the easiest ways to spot a microcap fraud is the heavy promotion of a company’s stock. Legitimate firms will almost always focus on advertising their products and services as that is what the company is selling. Any business wants to sell their products to you, the consumer, in order to make money. Authentic companies will not heavily advertise their stock directly to consumers as focusing on running a successful business will attract new investors. There may be some cases where a company promotes its stock for good reason, but heavy stock promotion should immediately ring alarm bells.
What Type of Business?The worst type of company to invest in is one with no actual business operations. Heavily advertised penny stocks could be stocks of dormant shell companies that have no underlying business. These can be pretty easily figured out with a little research. Trying to find out when the last time the company reported earnings or other financial information will immediately provide insight into whether the company is still actively engaged in business. Another huge factor in avoiding these scams is identifying where the stock actually trades, as the over-the-counter (OTC) market much less regulated than the big exchanges (NASDAQ, New York Stock Exchange) and so more likely to contain these shady stocks.
Stocks that are likely to be fraudulent will most commonly have very low prices, these so-called penny stocks can be manipulated as part of pump-and-dump schemes. These shady stocks will also commonly have frequent name changes or varying business focuses. Frequent name changes can help keep a fraud one step ahead of investors and regulators. Constant changes in what kind of business the company engages in should also be a major red flag as most legitimate companies don't change what type of business they're in very often. Often these scammy companies will purport to be in whatever businesses are "hot" in the market at a given time. In recent years, these have included companies associated with bitcoin or blockchain technology and cannabis companies. More recently, stocks related to electric vehicles or batteries have been extremely popular.
Trading TrendsThe simple act of analyzing a stock’s trading history will give a great indication as to whether or not the stock is fraudulent. Massive reverse stock splits are often performed by shady stocks to artificially inflate share price. Many stocks will perform these reverse splits to maintain a high enough price to remain on major stock exchanges. However, these splits usually range from 1-for-2 splits to maybe 1-for-50, while some shady operators may go up to 1-for-10,000.
Other unexplained jumps in share prices or volume spikes can be a sign of shady trading activity. Massive swings in trading price without related news about the underlying business is a prominent sign of a pump-and-dump activity. Finally, any trading suspensions by the SEC are a massive warning sign to any investor to not put their money into that particular stock.