Value Investing Blog

Penny Stocks

This is a guest post by my friend John, who is also the organizer of an investment club I'm part of. He is very knowledgeable and I love his writing style, so I'm sure you'll enjoy this article!

Hi, my name is John and I became interested in value investing after reading “The Superinvestors of Graham and Doddsville” in 2012. Nick asked to write a piece about “penny stocks” since he received several questions from readers on this topic.

"What are penny stocks? What is the hype about them? I was doing some research and some people claim that you can make more with penny stocks by shorting them? What does that mean? Are they legitimate? How does that compare with value investing? Can you buy penny stocks and hold them for the long term?"

Mussayab

"Please write something about finding penny stocks with potential to become billion dollar companies 3 to 5 years from now!"

Domingo

Let’s start with the definition of a “penny stock.” The government will tell you it is a share trading for less than $5 a share. That is not what we’ll be talking about today.

Sometimes a stock can fall in price to under $5 and be a great buy. Two of the stocks I own and that can be analyzed with Value SpreadSheet are trading for less than $5 today. They represent a partial ownership of real, profitable companies.

On the other hand, there are penny stocks of “companies” that don’t really exist in the way that you might expect. These “companies” are nothing more than smoke and mirrors. Just by saying that they might do something in the future, they are able to raise incredible amounts for their managers and owners, who have made no actual promises. They call themselves “development stage companies”. Some consist of real entrepreneurs who really want to change the world and create long term value for their shareholders. Many others have no real intention of doing anything but tricking people out of their hard earned dollars.

They make money by taking it from shareholders who buy at inflated prices and then selling quickly as the share price falls. This is called a “pump and dump”. To make sure they do not get sued by the Security and Exchange Commission these “companies” are incredibly honest about what they are doing. If you actually take the time to read their Annual (10-K Form) and Quarterly (10-Q Form) SEC filings you will come across their confessions.  These “companies” take money from gullible investors who don’t read the filings, do their own math and/or use tools like Value Spreadsheet.

Take for example the “company” Marilynjean Interactive Inc (MJMI). If you read their quarterly report 10-Q SEC filing you will come across the following confessions. 

 

Excerpts from Marilynjean 10-Q form

Going Concern: Will this company (concern) be able to survive going forward (in the future). In other words is the company going bankrupt and will shareholders lose all their money?

The accompanying unaudited consolidated financial statements for the fiscal quarter ended June 30, 2015 have been prepared on a going concern basis, which implies that our company will continue to realize its assets and discharge its liabilities and commitments in the normal course of business. Our company has not generated substantial revenues since inception and has never paid any dividends and is unlikely to pay dividends or generate earnings in the immediate future."

Read: We have never made or sold anything, we have no revenues (sales or turnover). We have never given money to shareholders in any way. “Unlikely to generate earnings” means -> we are never going to be profitable.

 

"The continuation of our company as a going concern is dependent upon the continued financial support from our shareholders, the ability of our company to obtain necessary equity financing to achieve our operating objectives, and the attainment of profitable operations."

Read: We can only survive if we can trick shareholders into giving us more money.

 

"As of June 30, 2015, we had cash of $5,571 and a working capital deficit of $190,153."

Read: We have no money; we have debt and a total “value” of roughly MINUS two hundred thousand dollars.

 

"These circumstances raise substantial doubt about our ability to continue as a going concern, as described in the explanatory paragraph to our independent auditors’ report on our most recent audited financial statements."

Read: The independent accountant, which we are legally required to hire to protect shareholders, says we’re going broke.

 

"The continuation of our business is dependent upon us raising additional financial support. The issuance of additional equity securities by us could result in a significant dilution in the equity interests of our current stockholders."

Read: We’re going to take money away from gullible people who don’t bother reading this SEC filing by selling shares.

 

Anybody Home?

There is no address or telephone number on their website. If you try to phone the “company” using the telephone number they provide in the SEC filing you get an anonymous answering machine that doesn’t take messages. Try it, call: 702-290-8649 The address they have to list is a kind of post office box. The man who is reported to be the President and Chief Executive Officer and Chief Financial Officer and Secretary and Treasurer and Director is a former police officer from Budapest who has only been with the “company” since April 2014. The buttons to social media: Twitter, Facebook, LinkedIn at the bottom of the site don’t work. On LinkedIn and Facebook it says the company is an online store that is planning on selling goods to pregnant women, whilst on the company website it says they’re thinking about doing something with Bitcoins. Three years ago the same “company” said it was considering Oil and Gas exploration. None of these businesses were actually started.

Warren Buffett’s teacher Ben Graham always told him: “Price is what you pay, value is what you get.” Obviously the value of this company is less than zero. So what do you think Mr. Market is paying for it today?

A thousand dollars? Ten thousand? Maybe even a hundred thousand for the website? No. As of today, October 29th 2015 Mr. Market is paying over $300 million for this non-existent company.  You can calculate this by taking today’s share price: $1,60 and multiplying that by the number of shares outstanding 195 million. The result is a market cap of $312 million!

In this case Mr. Market is clearly insane.

 

How the Owners Get Rich

The people behind the smoke and mirrors stand to make quite a bit of money. How is this possible you ask? I believe the reason is that "Most people would rather die than think; many do." as Bertrand Russell said. People judge a book by its cover and a company by the first impression they get from the website. They think fast instead of slow.

Compare Marilynjean's website: www.marilynjean.com to Berkshire Hathaway’s webpage (Berkshire is Warren E. Buffett’s company).

 

Marilynjean

 

You might be forgiven for thinking the first website is more exciting and attractive, but you will lose money if you buy MJMI shares to hold. People who do their own thinking and math know this.

Speculating in the penny stocks of fake companies is like playing musical chairs without any chairs. It might be fun during the “pump”, but you don’t know when the music is going to stop “the dump”, the people running the scheme do.  You can’t count on a stop loss if the stock price suddenly drops by 50%, which happens. Think and do your own math, invest in real companies that create actual shareholder value. You don’t need to join the penny stock game in search of even greater fools, whose money you might want to take. You’ll probably just learn an expensive lesson.   

So what will happen with MJMI in the next months and years? This time will not be different. I am even willing to going out on a limb: MJMI’s stock price might go up even further in the coming days or weeks, but if the market cap has not fallen from over $300 million to under $50 million within a year from today: I hereby publicly pledge to literally eat my Berkshire Hathaway baseball cap!

PS: If you’re interested in a website trying to uncover “pump and dumps” and the people behind them visit: http://www.theotc.today/

PPS: You can follow my stock picks and 5 year track record at http://caps.fool.com/player/ansgarjohn.aspx I am not as good as the Motley Fool’s owner David Gardner, but I am working on it. See the Motley Fool / David Gardner’s stockpicks for free by following this link: http://caps.fool.com/player/tmfspiffypop.aspx but remember to always do the math (using for example Value Spreadsheet).