From a reader:

I’ve been following your blog for a little while and appreciate your analysis. I’ve been particularly interested in your coverage on the penny stock phenomenon and started doing some of my own digging. I’ve found a few “companies” that seem to share characteristics with the ones you have highlighted. Digging into the 10-Qs reveals all sorts of red flags around related party transactions, health of balance sheet, past history of management, etc. The question I’ve been trying to answer is how these companies continue to exist? In the cases I list below their sole purpose appears to be to move cash from unwitting investors to the management of the company. 

Would be interested in your perspective.

Wanted to respond to you earlier, but time did not permit.  But thinking about it, I realized that for penny stocks, the most relevant statement to analyze is the Consolidated Statement of Changes in Stockholders’ Equity/Deficit.  You can see what prices they issued stock at.  Proceeds divided by shares gives you the internal valuation of where the company is willing to offer shares.  Few ask, but all should ask, “If the company is willing to issue stock at 30 cents per share for salaries, services, etc., why does the stock trade for $1 per share?”

Sometimes a merger, or a purchase of a business can inject money into a company; sometimes debts are settled for shares. That can temporarily grow the company, and combined with a reverse split, it can give it a share price and a market capitalization that seems respectable.

Number two is the hidden bidding up of the shares through sham transactions where related parties buy & sell at progressively higher prices (netting to no loss, aside from commissions) until some speculators see the microcap stock and start driving it higher, possibly supported by promotional paid research.

But here’s the hard part for me: Sometimes the companies are involved, sometimes not.  Sometimes I can tell how the promoters make money, sometimes I can’t.

This is what I suspect: Promoters have several shell corporations for promotion and trading.  Let’s say one has 4 shells.  When A promotes a stock, B, C, and D trade.  When B promotes a stock, A, C, and D trade.  When C promotes a stock, B, A, and D trade.  When D promotes a stock, B, C, and A trade.   Then each promoter can say they have no economic interest in the stock mentioned that they are “advertising.”

This is an ugly space.  Supposedly you can get a borrow on these bits of financial trash (in order to short them) through Interactive Brokers.

By David Merkel, CFA of Aleph Blog