Appendix D. Detecting Scams, Frauds, and Pump and Dump

If you’re like me, you probably get frequent e-mails from people you don’t know, advising you to buy stocks you’ve never heard of. These missives read like research reports from professional stock market analysts, profiling companies that have just developed exciting new products or services with huge market potential.

For instance, recently my new friends sent me tips about the following:

• A “renowned” computer maker that that was just about to introduce a line of laptops with astounding features that no other company could match

• A company about to introduce emergency 911 services for Internet-based long-distance telephone services

• A company that just successfully completed testing of a product that allows shipping of M&Ms candy by UPS instead of by refrigerated truck

I know that these stock-hyping e-mails work, because occasionally sI check the touted stock’s trading volume. Typically, the number of shares traded daily jumps by a factor of 5 or more for days after the e-mail.

The stories are always enticing. With dirt-cheap share prices, we could quit our day jobs if we got lucky and just one of those stocks took off. Alas, all too often those exciting stories are just that—stories made up to support a “pump-and-dump” scheme.

In pump and dump, promoters gain control of large blocks of shares of a small, probably dormant public company. The promoters “pump” the stock by issuing copious press releases announcing the firm’s entry into a variety of promising businesses.

These press releases become fodder for phony analyst reports circulated via e-mail and on websites that are in the business of publicizing stocks for a fee, regardless of the fundamental prospects.

The resulting publicity creates demand for shares, giving the promoters an opportunity to dump their holdings. Eventually, the promoters sell out and stop “pumping,” and the shares again become virtually worthless.

But even if they are not pump-and-dump promotions, many cheap stocks have good stories to tell but little chance of success.

Fortunately, it’s easy to spot those risky critters. This appendix describes six checks you can use to quickly rule out dangerous stocks, whether pump-and-dumpers or just bad ideas. You can find the needed data on Yahoo!’s Key Statistics report or on numerous other financial websites. You don’t need to tabulate the scores. Rule out any stock that flunks any single check.

Before you start, you should know that many dangerous stocks have never filed financial reports with the Securities and Exchange Commission. If any of the data points required for these checks are unavailable, assume that the company has not filed SEC reports. These are imaginary companies. Rule out all such stocks.

Rule #1: Last Price Is More Than $0.50

Most stocks worth your attention trade at $5 or higher. Stocks trading below that level are called “penny stocks,” and risk-averse investors won’t touch them.

That said, although it’s risky territory, there are solid businesses with stocks trading in the $3 to $4 per share range, and sometimes lower. However, the lower you go in terms of share price, the greater your chances of encountering bad ideas. Once you get down to $0.50 per share, in my experience, the odds are overwhelmingly against you.

There’s no point in wasting your time researching these stocks. Rule out all stocks trading below $0.50 per share.

Rule #2: Trailing 12 Months (TTM) Sales of at Least $25 Million

Most bad idea stocks have recorded few or no sales. Instead, they’ve issued numerous press releases announcing exciting new products and deals with distributors around the world to sell those products. Somehow, those great new products never make it to the marketplace, and the distribution deals never result in significant sales.

Most publicly traded companies with real businesses record annual sales of at least $50 million and usually $100 million or more. Rule out firms with less than $25 million in sales over the four quarters (12 months).

Rule #3: Market Capitalization of at Least $50 Million

Market capitalization is how much you’d have to pay to buy all of a company’s outstanding shares. Generally speaking, the lower the market cap, the riskier the stock. Risk-averse investors typically avoid stocks with market caps below $1 billion, and most savvy investors rule out stocks with market caps below $200 million or so.

That said, requiring a minimum $50 million market cap should be sufficient to rule out pump-and-dump stocks and other bad ideas. Avoid stocks with market caps below $50 million.

Rule #4: Institutional Ownership of at Least 5 Percent

Institutions are mutual funds, hedge funds, pension plans, and other large investors. Because they generate huge trading commissions, these big players are more wired into the market than you and I could ever hope to be. No publicly traded stock escapes their attention. Thus, if institutions don’t own a stock, it’s because most don’t think they can make money doing so.

Institutional ownership is the percentage of a firm’s outstanding shares held by the big players. Typically it runs in the 30-to-95 percent range. Anything below 25 percent is probably a bad idea. However, setting the minimum at 5 percent is good enough to rule out stocks with imaginary businesses. Avoid stocks with institutional ownership below 5 percent.

Rule #5: Debt/Equity Ratio of Less Than 3

Since they incur expenses but have no income, pump-and-dump stocks and other bad ideas typically carry high debt. The debt/equity ratio compares long-term debt to shareholders’ equity. A 0 ratio signals no debt. The higher the ratio, the higher the debt. Usually, ratios above 1.0 signal high debt. However, setting the maximum at 3.0 should be sufficient to rule out dangerous stocks that somehow passed the other tests.

Rule #6: Maximum Price/Book Ratio of 30

The price/book ratio compares the recent share price to book value, which is shareholders’ equity expressed on a per-share basis. Since bad idea stocks typically record few or no sales or earnings, the price/book ratio is the only useful valuation gauge. For most stocks, price/book ratios range from below 1 for value-priced stocks to 20 or so for in-favor growth stocks.

Since they have no significant assets, the price/book ratios for dangerous stocks are extraordinarily high. I set the maximum allowable P/B at 30. Stocks with ratios that high are a bad idea. Rule out stocks with a price/book ratio above 30.

Summary

These six tests should rule out stocks that have no real businesses. But that’s all they do. Passing these tests doesn’t necessarily mean that you would make money owning these stocks. You must read Chapters 1 through 18 to find winning stocks.