Penny Stocks: How To Investigate Them and Avoid the Traps

Information is the investor's best tool when it comes to investing wisely. But accurate information about "microcap stocks" -- low-priced stocks issued by the smallest of companies, often called "penny stocks" -- may be difficult to find. Many microcap companies do not file financial reports with the SEC, so it's hard for investors to get the facts about the company's management, products, services, and finances. When reliabwrongdoers can easily spread false information about microcap companies, making profits while creating losses for unsuspecting investors.
le information is scarce,
This Financial Guide gives you the basics about microcap or "penny" stocks, discusses how to find information on them, and points out what "red flags" to watch out for.

What is a Microcap Stock?

The term "microcap stock" applies to companies with low or "micro" capitalizations -- meaning the total value of the company's stock. Microcap companies typically have limited assets. For example, in recent 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.

Where do Microcap Stocks Trade?

Many microcap stocks trade in the "over-the-counter" (OTC) market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the "Pink Sheets."

• OTC Bulletin Board. The OTCBB is an electronic quotation system that displays real-time quotes, last-sale prices, and volume information for many OTC securities not listed on the NASDAQ or a national securities exchange. Brokers who subscribe to the system can use the OTCBB to look up prices or enter quotes for OTC securities.

Caution: Although the NASD oversees the OTCBB, the OTCBB is not part of the NASDAQ. Wrongdoers often claim that an OTCBB company is a NASDAQ company to mislead investors.

• The "Pink Sheets." The Pink Sheets - named for the color of paper they've historically been printed on - are a weekly publication of a company called the National Quotation Bureau. They are updated daily electronically. Brokers who subscribe to the Pink Sheets can find out the names and telephone numbers of the "market makers" in various OTC stocks - meaning the brokers who commit to buying and selling those OTC securities. Unless your broker has the Pink Sheets or you contact the market makers directly, you'll have a difficult time finding price information for most stocks quoted in the Pink Sheets. 

Which Companies File Reports With the SEC?

In general, the federal securities laws require all but the smallest of public companies to file reports with the SEC. A company can become "public" in one of two ways - by issuing securities in an offering or transaction that's registered with the SEC or by registering the company and its outstanding securities with the SEC. Both types of registration trigger ongoing reporting obligations, meaning the company must file periodic reports that disclose important information to investors about its business, financial condition, and management.
This information is a treasure trove for investors: it tells you whether a company is making money or losing money and why.