Red Flags to Watch For When Evaluating Penny Stocks

There are certain stock screens you can use to help weed out bad penny stocks. These tips should be used as part of your initial screening process along with other technical and fundamental screens to pick your list of acceptable penny stocks. Keep in mind these screens won’t be as useful once you have already invested in a stock, but they may save you some heartache upfront.

Trading Suspensions

An obvious starting place when you are looking for red flags includes looking for trading suspensions. If a company has violated any laws or rules their trading may become restricted.

You can start with the SEC, but you should also request suspensions from all the major exchanges as well as the OTCBB in case they used to be a larger company. If the OTCBB has suspended their account and the penny stock is only trading on the Pink Sheets this stock is likely going down in a burning flame.

Return on Assets (ROA)

If the company has a lot of assets, but their returns are very low from those assets, like less than 5%, then you should question the company. This is because return on assets less than 5% could be made by just selling everything and investing in something else that is probably safer. Why expend all the time and effort to run a company for such a small profit gain? Perhaps the company has a plan and it hasn’t materialized, but it is just as likely that they have inflated their assets to meet a minimum listing threshold.

Check the Footnotes

If the company does supply financial reports they will record any unusual transactions. These odd transactions are usually found in a string of foot notes in really small font. The big red flags include loans to individuals, buying assets with stock, selling stock for assets, or special sales of product that don’t match the average sales. When you find these transactions it’s possible the investor’s best interest might not be at heart. The attempt may be to filter money out of the company to other individuals or organizations without paying shareholders their fair share.

Increase in Internet Activity

If the company has been around for years, but you’ve only recently noticed people talking about it in chat rooms, forums, websites, or emails you may be seeing the formation of a scam. Often this internet chatter is paid for by a large share holder to generate interest in the stock. The same can be true if your broker just now starts pushing the company or if it is suddenly being pushed by high pressure sales people on the phone. Remember, fraud is particularly common in this market.

Auditing Issues

If you find out auditors won’t certify their financial reports or they won’t audit that company anymore this is a huge flag that the company is violating rules and the auditors don’t want to be involved.

Bad Stock Brokers

Find your favorite sleazy stock broker, you know the ones that always have the once in a lifetime deals or always claim they know the top penny stocks, and just cross their stocks off the list. These guys will push any stock that pays them a huge commission. Lying is easier than finding good results. I would just get on a bunch of these guys email lists (to a separate email account of course) and take note of their recommendations so you can scratch them off of your list.

In summary penny stocks are risky. However, it doesn’t mean you shouldn’t have any in your investment accounts. You can significantly reduce your risks by quickly screening the stocks for some red flags. These screens can’t be done automatically, so I would use a combination of technical analysis screens and fundamental screens first to reduce the number of stocks you have to manually review.