I’ve always been attracted to micro-cap investing, mostly because of the high risk yet high reward aspect to it. Yes you have to sift through a lot of crap stocks to find those few gems that can become 5 or 10 baggers (i.e. 500% and 1000% gains) but where else can you find stocks that offer the potential for such amazing yields? The problem is however that due to the evident appeal of penny stocks, the “wild west” attitude that many brokers have towards them unfortunately leaves new investors open to fraud, unless they remain diligent when monitoring their trading accounts. There a number of signs to watch for in order to avoid penny stocks that may be involved in fraudulent activities. Learning to spot these signs will protect you and your trading accounts.
#1 – High Pressure Sales Tactics
The first thing to look out for is brokers who are using very high-pressure sales scripts and techniques to get you to invest in these stocks. However, the fundamentals of a stock that sells for under $5 are no different from the underlying things you look for in a blue chip issue. A company does not become a good investment overnight; it takes time and work to build strong fundamentals whether it be up and coming small-cap Canadian stocks or a typical Nevada startup.
#2 – Blind Pool Investment Management
Many brokers who offer Initial Public Offerings (IPO) in small companies may offer them to their clients in blind pools. A blind pool is the pooling of funds where you the investor allow the broker to decide how to invest your money without you the investor knowing anything about what is being purchased. Often times a blind pool has exorbitant management fees and outrageous promotional bills just to get the project off the ground. Being involved in a blind pool is like giving a burglar the key to your home for safekeeping.
#3 – Errors on Your Broker Statements
Watch your account statements very closely. Brokers are required to do their “due diligence” on all issues they offer their clients. In order to avoid regulatory problems, an unscrupulous broker may mark trades as unsolicited when in reality the trade was clearly solicited by the firm. Sometimes this may simply be a mistake but you cannot be too careful. In addition, brokers who are trying to make quotas will fill out investor profiles that have misstated net worth, investor ability, income and account objectives. This allows investors who are not ready for speculative investments like penny stocks to participate.
#4 – Unauthorized Transactions
Occasionally transactions that you do not authorize mysteriously show up in your account. Fraudulent brokers may pressure you to buy or keep this stock even though you do not actually want them. At other times, a technique known as “parking” may be happening. This is when a broker needs to meet distribution requirements for an IPO. While these transactions are often mistakes, you need to have your account corrected immediately. It is best to make these changes and record them by phone and in writing so that your investing activities remain above board. If this happens with any type of frequency, you would be wise to report it to the investigative division of the securities commission.
