The longer you invest, the greater your likelihood of running across investment fraud. According to the Securities Investor Protection Corporation, regulators estimate that $10 billion to $40 billion is lost to investment fraud in the U.S. every year. The firm attributes $1 billion to $3 billion of that total to microcap stock fraud.
One of the most well-known cases of microcap stock fraud is that of Jordan Belfort, whose memoir, The Wolf of Wall Street, was adapted into a film in 2013. He plead guilty to fraud in connection with his firm Stratton Oakmont, a boiler room which marketed penny stocks using pump-and-dump schemes. Many penny stocks are microcaps, which are companies with market values of less than $250 million.
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One reason microcap stocks are more susceptible to price manipulation, according to the Securities and Exchange Commission, is because publicly-available information about them is often scarce, making it easy for fraudsters to spread incorrect information. It's also easy for fraudsters to manipulate microcaps because they are typically less liquid than other stocks.
Red flags for microcap stock frauds
Here are some warning signs that could have tipped off Jordan Belfort's victims (or anyone else who runs across suspicious microcap stock activity). The SEC describes several things to watch out for. The first is unsolicited stock recommendations or promotions. Regulators say that if a company's stock is more widely publicized than its products or services, it's a dead giveaway that it could be fraud.
Another is a lack of any real business operations. Some stocks are for empty shell companies with no real operations. This goes along with the first red flag because if there are no actual products or services, then there won't be much to advertise aside from the fake company's stock.
One other thing to watch for is an unexplained increase in the stock price or trading volume. Many microcap stocks are traded on the over-the-counter systems. Tracking the price and volume may give you a hint about suspicious activity. The SEC also suspends stocks when suspicious activity is detected, so whenever you are dealing with microcap stocks, it would be a good idea to check, which you can do so here.
Another red flag is if the company frequently changes its name or business plan. Sudden changes in the types of products or services offered can suggest there are no real operations underway.
How to avoid getting taken by the Wolf
ValueWalk typically doesn't feature penny stocks because of the risk of fraud, but there are ways to locate information about microcaps if you are set on investing in them.
The SEC's EDGAR research database offers free access to publicly-available information. This is the best way to find information about any company because you're reading what the company itself is putting out instead of reading what others are saying about the company. A lack of information can be a red flag, although it's not uncommon with microcap stocks. Another potential source of information on microcap companies is the OTC Markets website.
Remember that fraudsters often promote microcap stocks via seemingly unbiased and independent sources like social media, investment research websites or newsletters, email, direct mail, magazines, newspapers and radio. As a result, it's always best to do your own research to find out what the company is saying rather than just listening to what "wolves" like Jordan Belfort are saying about it.
This article first appeared on ValueWalk Premium