ZZ Top and Hondo Valley: Why you should never buy a small-cap penny stock

In general, the rule to investing and trading penny stocks (any stock trading at less than $5 is typically consider a “penny stock”) is: Don’t invest or trade penny stocks.

Because they usually have such small market caps and so few shares outstanding in the markets, they are easily moved higher for the short-term, often enabling insiders and their cronies to run up the stocks temporarily so that they can sell as many shares as they can while the stock is up. Let’s talk more about this as there’s always a ton of questions from everybody I know about such and such penny stock, and there’s some easy flags to see when you should run from a particular penny stock.

A couple years ago, I’d been invited by a friend to a ZZ Top concert at Beacon Theatre in NYC. My friend was friends with Billy Gibbons and Gibbons’ wife, who was into the markets and they’d invited me backstage to hang out after the show. We eventually ended up on ZZ Top’s tour bus and in between me getting to pick a little bit on Billy’s 1960s Les Paul and talking about how much he loves the Inn of the Mountain Gods in Mescalero, NM, his wife and I were talking stocks. And then the conversation turned to a penny stock that she owned and I set the guitar down because I was pretty sure where this talk was about to go.

The stock she wanted to know about was WTER.OB. A “.OB” stock which means that it was either so small or had a rough enough history that it couldn’t even get listed on a major exchange. Not all .OB stocks are trash, but most of them are, and that’s a huge red flag already.  This was before we had iPhones and I wasn’t going to sit there and pull up the stock and research it for her on ZZ Top’s tour bus anyway, so I told her I’d email her some analysis.

A few months ago, I was at my dad’s farmhouse in Hondo Valley when a telephone company utility truck pulled down the drive. Our longtime neighbor hopped out and wanted to know if I had a minute to talk stocks. He wanted to know if I had any opinion about a particular penny stock, RAYS, that he had been told was ready to hop 10-fold. We were out on the farm so I told him I’d take a look at it when I got back to the office and would shoot him an email. But again, hearing a casual investor/trader ask me about a penny stock was already a red flag for me.

Though the details of each of the above anecdotes are worlds apart — a rock star’s wife in NYC and a utility worker in rural NM, WTER made water purification systems and RAYS does Internet streaming video compression — it was very easy for me to quickly determine that these were both screaming “sells” and that I wouldn’t touch either stock with a ten foot pole.

Both stocks collapsed after I warned my friends about them and in fact, there is no such stock trading under the WTER symbol at all any more.

Take a look at the “news” releases for RAYS at the time my neighbor was asking me about it and you’ll see plenty of red flags right here:

Marketwire? That’s not Marketwatch people. It’s a news wire upon which anybody or anyone or any company can buy a press release and Yahoo! Finance and many the other news services will pick it up there as news. “But,” my neighbor asked, “aren’t all those research reports talking about RAYS and NFLX and AKAM saying that this stock and their technology are about to explode?”

Sure, if those reports are from a reputable research shop, especially if you are sure that the report writers and the company are wholly arms-length. But are they? Have you ever heard of the companies issuing that research? And more to the point, as I mentioned above, are you sure that the company or its controlling shareholder didn’t pay someone to write that research?

When you see press releases touting a research report touting a penny stock, I would run for the hills. I haven’t played the lottery once in my life, haven’t even contributed a dollar to the office funds when the jackpot is through the roof, but I would probably rather buy a lottery ticket than just about any small-cap (less than $250 million market cap) penny stock.

Here’s an interview on my show from Fox Business that I did with a penny stock promoter from a few years ago:

I was intense, I know, but how many people like my friends in the anecdotes above have lost money when they’ve bought a small-cap penny stock being promoted by someone being paid to promote it. It’s hard enough making money in the market when your research resources aren’t biased. And few small-cap penny stock news releases and the research reports they tout are unbiased. My old pal Tim Sykes is making a career out of finding and shorting these kinds of promotional small-cap penny stocks. That’s probably the only way to make any money in penny stocks — shorting them when they’re in the spiked promotional phase.

Be careful with your money. I have made a lot of money for a lot of people by buying revolutionary technology companies of any market cap size and shorting companies whose government-sponsored business models are failing. I don’t know anybody who’s made big money consistently ever in penny stocks. Don’t even try.