Beware of 'pump-and-dump' stocks

By Harry Domash

If you're like me, you probably receive frequent e-mails from people you don't know, but who apparently like you enough to let you in on amazing investment opportunities.

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

• A "renowned" computer maker 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 (VoIP) long-distance telephone services.

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

These stories are enticing. With dirt-cheap share prices, we could quit our day jobs if we got lucky and just one of these stocks took off. But, alas, all too often those exciting stories are just that: stories made up to support a "pump-and-dump" scheme.

Bilge pump

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

These announcements become the fodder for phony analyst reports circulated via e-mail and on Web sites in the business of publicizing stocks for a fee, regardless of their 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.

It's not just pump-and-dump schemes that present a problem with the smallest of stocks. There are many cheap stocks around that have good stories to tell, but have little chance of success.

Fortunately, it's easy to spot those risky critters. Here are six checks you can use to quickly rule out dangerous stocks, whether pump-and-dumpers or just bad ideas. You don't need to tabulate the scores. Rule out any stock that fails to meet any single check.

Rule #1: Last price above 50 cents

Most stocks worth your attention trade at $5 or higher. Stocks trading below that level are called "penny stocks," and risk-averse investors wouldn'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 50 cents a share, in my experience, the odds are 100% against you.

There's no point in wasting your time researching these stocks. Rule out all stocks trading below 50 cents a share.

Rule #2: Last-quarter sales at least $10 million

Most pump-and-dump stocks have recorded little or no sales. Instead, they've issued voluminous media releases announcing exciting new products and deals to sell those products with distributors around the world. 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. You can see a firm's quarterly revenues for the past three years in the Financial Results -- Highlights report (using Citigroup (C, news, msgs) as an example in this case). Avoid companies with recent quarterly sales below $10 million.

Note: many pump-and-dump stocks have never filed financial reports with the Securities and Exchange Commission. Since no data is available, the quarterly revenue figures, as well as other financial data, are not available. These are not real companies. Rule out all such stocks.

Rule #3: Market capitalization at least $50 million.

Market capitalization is the total value of a company (shares outstanding multiplied by the recent share price). Most market experts consider larger companies to be safer investments than smaller ones. Risk-averse investors usually stick with market capitalizations above $1 billion, and most investors rule out stocks with market caps below $200 million or so.

That said, a $50 million minimum should be sufficient for our needs. Rule out stocks with market caps below $50 million.

Rule #4: Institutional ownership at least 15%

Institutions are mutual funds, hedge funds, pension plans and other large investors. Because they are such big players, there is no publicly traded stock that escapes their attention. When a new stock is brought to market, the investment bankers handling the IPO (initial public offering) make presentations touting the stock to all of the institutional buyers they can round up. No matter how small and obscure the company, it should fit some mutual fund or other institutional buyer's game plan. Thus, if institutions don't own a stock, it's because none of them think they can make money doing so.

Institutional ownership is the percentage of a firm's outstanding shares held by the big players, and typically runs in the 30%-to-95% range. Anything below 25% or so is probably a bad idea. However, setting the minimum at 15% is good enough for our needs. Avoid stocks with institutional ownership below 15% (shown in this site's Company Report).

Rule #5: Debt/equity ratio less than 3

Since they incur expenses, but have no income, pump-and-dump stocks tend to carry high debt. The debt-to-equity ratio, which is total debt compared to shareholders equity, is the most widely used debt measure. Firms with no debt would have zero debt/equity, and the higher the ratio, the higher the debt. Usually, companies with ratios above 1.0 are considered high-debt.

For us, setting the maximum at 3.0 should be sufficient to rule out pump-and-dumpers or other dangerous stocks that somehow passed the other tests.

Rule #6 Maximum price/book ratio of 30

Since they typically have little sales, and no earnings or cash flow, the price-to-book ratio (recent share price divided by book value) is the only useful valuation gauge for potential pump-and-dump stocks. Price/book ratios range from below 1 for value-priced stocks to 20 or so for high-growth stocks.

Since they have no significant assets, pump-and-dump and other dangerous stocks will probably have extraordinarily high price/book ratios, so I set the maximum allowable ratio at 30. Avoid stocks with price/book ratios above 30.

These six tests should rule out stocks that have no real businesses. But that's all they do. You will not necessarily make money by simply holding stocks that pass these tests. Finding winning stocks requires more research.