How The Penny Stock Prince Could Butcher Your Portfolio

In the summer of 2012 John Babikian, aka the Penny Stock Prince, disappeared.

The 26 year old had just spent the previous 5 years turning a small upstart e-business housed in his mother’s den into a widely recognized internet titan.

Awesome Penny Stocks wasn’t just big — it was monolithic. In just a handful of years the initially irrelevant website had grown to have over 700 000 email subscribers who eagerly lapped up the tiny stocks that Babikian recommended each month.

The arrangement was enormously profitable. Babikian would start by buying up blocks of stock and then begin hyping the firm through his email list. In two months, a prescription drug company he recommended soared to over $ 700 million — and that was just one of hundreds of trades.

Flush with cash, he soon began throwing the proceeds into shell businesses to use as investment vehicles, as well as expensive Los Angeles real estate, private airplanes, and even a million dollar Bugatti Veyron. When allegations of tax evasion began to surface, however, Babikian dropped everything and fled his home province of Quebec not to be seen again.

Securities and exchange commission officials estimate that Babikian was able to boost the value of his holdings by as much as $ 3 billion when all was said and done — nearly all of that money taken from members of his mailing list.

Could the Penny Stock Prince Butcher Your Portfolio?

Movies such as Boiler Room or The Wolf of Wall Street have shone a light on the retail brokerage industry’s dark underbelly.

Years ago, teams of sales people gathered together in smoke-stained offices to start pushing stock in tiny unknown companies through evening cold calls. Brokers would first identify a specific stock, scoop up shares, and then begin working their way down pages of leads hoping to convince ordinary people to purchase the shares. After the price of the stock had soared high enough the brokers quietly sold their stakes at massive profits.

Boiler rooms have become much less significant when it comes to pump and dump operations. Now, kids just out of high school can start a website, put an email list together, and start hyping a company’s stock in the hopes of passing it on to other retail investors. In the end, those same retail investors end up holding expensive shares in a worthless company.

So Should You Avoid Penny Stocks Altogether?

Unfortunately, the term “penny stock” has just become a derogatory name for a stock trading below $ 1. Still, a case could definitely be made for avoiding them altogether.

People are generally attracted to penny stocks because of the perception that it’s incredibly easy to make a lot of money very quickly by buying them. The idea is that if you buy cheaply enough and one of these tiny businesses begins to take off then the inevitable returns would be astronomical.

Of course, there’s often a profound lack of information about companies with shares priced below $ 1 and this is where a lot of the market manipulation comes in.

Stock tips and anonymous sources have a very powerful voice in the world of penny stocks. Like clockwork, many retail investors wait for stock tips from people who are allegedly closely connected with, or have some sort of expert knowledge about, a company and then buy on the advice of these experts. As more investors pile in, people buy at higher and higher prices. Once the hype starts to fade, investors who bought in well above fair value can lose their entire invested principle.

Obviously you could avoid these devastating losses by just staying away from penny stocks all together. That’s the knee-jerk reaction that a lot of value investors take, citing difficulty telling which firms show genuine promise, and frequent stock scams.

These concerns miss the real issue, however. The problem isn’t actually with penny stocks, the lack of information that often accompanies them, or the crooks who hype them — the problem is with the attitude that some investors take toward their own investments.

It’s Not the Hype — It’s You.

Massive profits exist in the world of penny stocks, but only if you’re an intelligent investor.

Within the world of ultra-cheap stocks is a real diversity of opportunity. Many investors wouldn’t know that because of the reputation that penny stocks have gotten over the years and the near total avoidance by investors who consider themselves “sophisticated”.

Of course, it’s easy to understand the pain of loss that comes with being scammed but the problem isn’t with the hype that surrounds some of these companies — the problem is with a buyer’s failure to invest intelligently.

Rather than just taking the word of another person, no matter who it is, you should always perform the diligence necessary to tell whether the investment in question is a real opportunity or not. That’s the minimal requirement for intelligent investing or intelligent speculating.

There’s nothing wrong with reading stock forums or being a part of an investment newsletter to source investment ideas. Many of the best value investing sites have newsletters and, just like the free net net stock ideas that I suggest through NetNetHunter.com, the majority of those newsletters recommend stocks.

As an investor, though, you owe it to yourself and your family’s finances to take a deep look at the fundamentals of the business before diving into a position. Not doing so ultimately means letting other people take advantage of you.

You have very few friends in the world of investing. As an investor, you want to know the strategy behind your purchase and then dig deep enough to see whether the stock fits your strategy and what the risk-reward relationship is like. You never want to just blindly invest based on the advice of someone else.

How to Make Buckets of Money in Ultra-Cheap Stocks

I always get a kick out of it when someone says that a stock is more risky, or less of an investment, just because it’s trading below $ 1. If that were the case, then a reverse stock split could suddenly morph your “risky penny stock” into a solid investment opportunity.

How ridiculous is that?

The truth is that serious bargains exist in the world of penny stocks. Sure, you get the absolute crap that stock operators like to hype — and there are a lot of those worthless companies trading below $ 1 — but you also get firms with real underlying value and promise. Many of the stocks that trade below $ 1 are NASDAQ stocks, or former NASDAQ stocks, that have been hammered and now offer investors solid deep value opportunities, for example.

Just take a look at one of the stocks that Joseph Geronimo, a Net Net Hunter member, identified in October:

The point of the graph is to show how you can profit by finding solid companies with stocks trading below $ 1 and at obvious discounts to intrinsic value. Not all net net stocks rebound by the amount shown in the graph but most of the net nets that I’ve invested in have work out very well.

In the above case, InfoSonics had a rock solid NCAV, had no debt, a massive current ratio, and over 30% of the stock was owned by management. Try finding large cap bargains like that…!

Here’s another example:

I brought up Sangoma Technologies on our Net Net Hunter forum last fall when it was priced at $ 0.19/share and ended up buying at $ 0.20.

The firm had just spent a lot of money developing 19 new products and was shifting investment from R&D to sales. 40% of sales were coming from new products before the company had started pushing its newly developed products. It had no debt, was buying back stock, had a solid current ratio, had operated profitably since 1984, and management owned 18% of the shares outstanding. It was also trading at just 55% of NCAV.

Talk about opportunity!

The company is no longer a real net net bargain but investors can make a lot of money if the company can regain its former level of profitability. Members who got in when it was recommended on Net Net Hunter last fall could end up making 240% within a couple years if the company regains even half of its 2010 profitability.

Again, these are just two examples of the types of bargains you can find in the world of penny stocks.

Of all the net net stocks that I’ve bought over the last 3 years, most traded below $ 1 at the time of purchase. My NCAV stocks have worked out with a lot of regularity and have helpedmy own portfolio outperform the market by a very wide margin over the time period.

Of course, it’s helped that I’ve heavily screened net net stock investment opportunities by using a rigorous NCAV scorecard based on the principles of Benjamin Graham and a number of scientific studies that have looked at net net stocks. The companies that I’ve purchased have all had long histories of profitable business, have been backed by solid value, and have been very conservatively financed. Many have either been buying back their own stock, have seen active insider buys, or have even been priced under net cash (cash less ALL liabilities).

You can’t find these types of bargains when investing in large caps.

It’s also helped that I’ve ignored most of the noise that exists on stock forums, keeping a very independent mindset. Investing in just any stock trading below $ 1, or buying based on recommendations rather than my own analysis, could have been a recipe for disaster.

You don’t even need to adopt a classic Benjamin Graham net net stock strategy to make money in penny stocks. As long as you’re a knowledgable value investor basing your purchase on some solid measure of value you can do well with stocks priced below $ 1. There are many ways to make money through value investing.

The catch to all this is that you have to be running a smaller portfolio — sub $ 10 million — in order to purchase many of these stocks. Low liquidity just hasn’t been a problem for me but that will change when my portfolio rises above $ 1 million and I would be completely priced out of these stocks above $ 10 million. That’s a major advantage that you have as a small investor, and why this niche is still open to you if you want to invest intelligently.

Large price spreads haven’t been an issue, either. Some people are afraid of the bid-ask spreads that come with cheap stocks, thinking that their entire profit would be eaten away when buying. That just isn’t the case, however. I routinely buy these stocks for their quoted market value by placing limit orders and, in a minority of cases, tiptoeing into the stock by making 2 seperate purchases.

Selling is even easier. When the stock price eventually takes off so does volume making it easy to sell your entire position.

Don’t Assassinate Your Small Investor Advantage

As a small investor, an investor managing less than $ 10 million, then you can achieve the highest possible returns by seeking out great opportunities in areas of the market that just aren’t open to larger investors. That means leaving the anaemic opportunities in the medium or large caps arenas to the pros, or people who blindly follow Warren Buffett, and embracing areas of the market that other investors overlook.

Buying stocks trading below $ 1 is one of those niche areas, but you have to be smart about it. Investing based just on the advice of other investors, is a fool’s game. You owe it to yourself to do better than that.