Investor Toolkit: Beware of name-dropping promoters when you buy penny stocks

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on the fundamentals of successful investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “Beware of companies that are more interested in boosting their stock than in building their business.”

Penny stock promoters love to make deals with major, household-name companies. That’s because they think the public is far more likely to buy penny stocks that have agreements with Teck Resources, BHP Billiton or some other major mining company to finance exploration of their mining claims. Or if Sony, Apple or some other household-name multinational has agreed to evaluate their computer program or electronic gadget. The link with a major gives them instant credibility, especially with investors who buy penny stocks.

• Exaggerated involvement: When they get a deal with a major, promoters often go to great lengths to make it seem bigger than it is. Instead of announcing that the big company has invested, say, $50,000, a stock promoter may issue a press release that says the two companies have entered into a “multi-stage development plan.” The release may say the major has agreed to spend “up to $10 million” or whatever. It will usually provide a toll-free number for investors who wish to call and order the glossy brochures.

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• Big companies have more leverage: It pays to remember that a big company doesn’t go into a situation like this the same way you do, as an individual investor. If the big company agrees to spend $50,000 to study the property, program or gizmo, it will also insist on a series of options that let it invest ever-larger sums on favourable terms. But the big company will always reserve the right to drop out and cut its losses. In most cases, it will exercise that right to drop out.

  A major mining company will gladly spend $50,000 one hundred times, and lose every penny of it — a total outlay of $5 million — if this means it will get a chance to develop the one rare project that’s worth the investment of, say, $500 million. If it waits till the property, program or gizmo has proven itself, development rights will be much more costly. So it gets in early by investing what are, for it, token amounts of money. That’s why big-company involvement by itself is never a good reason to buy penny stocks.

• Good time to sell: In fact, when a penny stock shoots up on the news of big-company involvement, and the property/program/gizmo is still in the early stages of development, it’s often a good time to sell.

Next Wednesday, July 21, 2010, Investor Toolkit will give you a simple strategy for cutting your risk when investing in the stock market.

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