Harry Domash's Winning Investing


Watch Out For Pump & Dump

I receive almost daily emails from self-styled stock research firms alerting me to opportunities to get in on the ground floor of exciting new businesses. These might be companies that are close to developing cures for cancer and/or HIV, have recently discovered rich gold deposits in Nevada, have developed a transmission system that increases Internet speeds by a factor of 10—I think you get the picture.

While these stories are intriguing, alas, many of these firms are more interested in making money from selling stock to unsophisticated investors than they are about starting groundbreaking new businesses.

Many of them start when their promoters acquire a defunct “shell corporation,” that is a corporation with publicly traded stock, but with no significant business. They typically pump up the stock price via an intensive email campaign and then dump their holdings when the share price is peaking. Hence, the name, “pump and dump.”

Fortunately, you can easily spot pump and dump stocks as well as other bad ideas. Here are six quick checks that you should apply to every stock that you’re considering. It won’t take long because you’ll disqualify a stock as soon as if fails any one of these checks. The needed information is readily available on many financial websites. I’ll use Yahoo! to demonstrate the process.

#1: Current Stock Price
You can avoid many bad ideas by simply checking the recent stock price. Do that by getting a price quote on Yahoo’s main finance page (finance.yahoo.com). Most worthwhile stock candidates trade well above $5 per share. If you’re a conservative or risk-averse investor, rule out stocks trading below that level.

However, some viable candidates do sink below that level and then recover and go on to do great things. If you’re okay with taking on some risk, it’s okay to consider cheaper stocks, but be cautious about any stock trading below $1 per share, and avoid all stocks changing hands below $0.50.  

#2: Recent Prices
Stocks that have been heavily promoted via email often move from below $0.50 per share to $1.00 or more during the campaign. Use Yahoo’s Historical Prices report to check a stock’s recent trading history. Rule out stocks that have mostly traded below 50 cents per share.

#3: Annual Revenues
Select the Income Statement (Financials section). Yahoo displays the last three fiscal year’s numbers. The top line of each column shows the total revenues (sales) for the year. Most public corporations crank out sales in excess $50 million annually, which would, since Yahoo lists the figures in thousands of dollars, be displayed as 50,000.

Risk-averse investor should disqualify companies with less than $50 million in sales. Otherwise, use $10 million as your minimum.

#4: Quarterly Revenues
For more recent data, select the Quarterly Data option, which shows the last four quarter’s sales figures in the same format that was used for annual sales.

All corporations doing any kind of business at all should be racking up sales of at least $5 million per quarter. Disqualify any company that doesn’t meet that requirement for the most recent quarter. Risk-averse investors should require at least $10 million.

#5: Solvent?
Next check the company’s solvency by selecting Balance Sheet (Financials section) and then Quarterly Data. Use the most recent quarterly data.

The balance sheet shows assets (what a firm owns) and liabilities (what it owes). If liabilities exceed assets, the company has a problem. Current assets and current liabilities are the best way to measure a firm’s financial strength. Disqualify any companies whose current liabilities exceed current assets.

#6: Change of Business
While still on Yahoo, select SEC Filings (Company section) and pick the most recent Quarterly (10-Q) or Annual (10-K) report. Click on the Summary link and read the Overview section. This will only take you a couple of minutes. Disqualify any company that has recently completely changed its business plan (e.g. from mining to high-tech), typically as part of a merger.

Doing these six quick checks will eliminate most stocks that don’t have real businesses. But passing these tests simply means that you’re dealing with a real company, not that you’ll make money owning its shares.

updated 9/9/12

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