Learn these basic terms and actions that affect penny stock prices. A good understanding of them will help boost your knowledge of a company's market standing and assist you in deciding which penny stocks to buy.
Positive Actions
Reverse Merger
A private company may use a reverse merger, or reverse takeover (RTO), to become a public company. The original public company, also known as a shell company or shell stock, usually has no substantial value or assets other than a listing for public trading (having a stock symbol) at a particular exchange. To perform a reverse merger, an already public company will issue shares to acquire a private company that has a business and actual value.
Private companies normally use initial public offerings (IPOs) as the standard way to go public. Compared to an IPO, a reverse merger offers a cheaper and faster way to become public. However, unless a dilution occurs after the completion of a reversed merger, the company can't raise capital through this process.
For penny stock investors, a reverse merger offers the most profitable venture. The reversed merger stocks have the volatility to explode more than 1,000%, and these stocks offer a good trade on a short-term basis. If a legitimate company with realistic claims and a sound business model undergoes a reverse merger, it may offer a good long-term investment. These types of stocks slowly work their way toward fair market value as investors methodically accumulate shares.
Beware of scammers who may use reverse mergers to create pump and dump scams and be wary of companies that proclaim outrageous profits, assets or future projections.
Forward Split
A forward split (F/S), commonly done at a 2 to 1 ratio, stands opposite the reverse split. A shareholder owns two shares at half the previous price of each owned share after a forward split. Companies do forward splits to bring high stock prices down to attract smaller investors. Forward splits signal a company's growth and the continuance of a share price increase. Forward splits rarely occur with penny stocks due to an already low price per share (PPS). Penny stock companies have more interest in a higher price, which is required for uplisting to bigger exchanges such as the New York Stock Exchange (NYSE) or NASDAQ.
Uplisting
In the uplisting process, a company's stock moves to trade on a higher exchange. In the penny stock arena, the most common uplisting is from Pink Sheets to the OTC Bulletin Board (OTCBB). Uplisting from the OTCBB to a big board like the NYSE or NASDAQ occurs rarely, as only a few penny stocks succeed to the point where they meet the requirements for a big board listing. Uplisting also signifies continuous growth and success, and stocks that succeed to uplist show real promise as a good investment.
Beware of companies that promise an uplisting and then don't deliver. Uplisting takes a substantial amount of time and money due to the required audits, paperwork, legal issues and other steps needed to make the jump. No announced deadlines, missed deadlines and scarce information on the company's financial performance should raise your suspicion. These actions signal that the uplisting news may have only served as a ploy to create a buy-in so the company can sell its shares at a higher price.
Buyback
Once a company starts purchasing shares from the open market, we talk about a stock buyback. The company issued shares to raise the initial capital during the formation of the company, and it can buy back shares to increase their value and entice investors to purchase and hold their positions. A buyback is essentially the opposite of dilution, and it has a very positive effect on the stock price. Successful companies that value their shareholders have been known to channel profits into a buyback program.
Penny stock investors must be wary of scams that promise a stock buyback. The communication from the company may state that it intends to buy back a certain amount of shares, but without stating the amount or percentage. Without stating the number of shares slated for buyback, the company may buy back a miniscule amount and use this good news to sell shares. To stay safe, invest in companies that show a solid business model or trade on bigger exchanges (OTCBB or higher).
Negative Actions
Learn about negative actions that penny stock companies can make, as it will help you identify companies not worth investing in. Your knowledge and ability to realize a bad situation sooner than others will allow you to sell your position before the price drops to distressed levels.
Dilution
Dilution means that a company issues additional shares to its outstanding share count and intends to raise capital for the company. The number of shares increases, while the company value remains the same, leaving more shareholders with less value. The additional shares dilute the value of all shares on the market. The impact of dilution can ruin a shareholder's position in a stock.
With increased supply and unchanged demand, selling new shares drives the stock price down and a careless company can send its stock into a spiral that damages the company's value and its shareholders.
Reverse Split
Companies use a reverse split (R/S, RS) to reduce the number of shares on the market and increase the stock price. Reverse splits follow a specific ratio, usually 10 for 1. This ratio means that if a shareholder held 1,000 shares valued at 1 cent, he or she would be left with 100 shares valued at 10 cents after a reverse split, but the total value of the stocks would remain unchanged.
A reverse split normally results in a large selloff by remaining shareholders, causing the price to plummet. Companies arrange for reverse splits to increase the price of the stock to more attractive levels, or to remain at a minimum price for a particular exchange. Reverse splits cause the percentage of shares on the market to decrease, increasing the price back to a dilutable level, and enabling bad penny stock companies to continue raising capital through dilution. A "dilution gyre" can spin over and over until it goes out of control. Once out of control, it will leave a stock worthless, leaving it at the minimum price that stocks trade at: $.0001. If the company hits this low, it can't effectively raise capital by selling any more shares.
Dividend
A company may decide to pay its shareholders a dividend. A dividend represents a portion of a company's profits paid out to stockholders. Dividends come as either cash or stock from company earnings. Penny stock companies often pay dividends in the form of extra shares. Shareholders receive a number of shares determined by a percentage of their current share count. Although they appear as incentives to hold a stock, issuing dividends may turn out to be a negative tactic. With penny stocks, a stock-based dividend essentially means a dilution while enticing shareholders to buy or continue to hold the stock. With shares coming to investors, many will sell, leading to a share selloff.
Some professionals argue that dividends may also serve to create a short squeeze. If the stock has a large short, or naked short position, issuing a dividend can force the naked short sellers to cover the short sale. This results in buying and creates a rapidly rising stock price, known as the short squeeze. Investors should beware, as no method can prove whether the short position even exists until the short squeeze passes. The company may publicly stand against naked short sellers while playing along behind the scenes. If the short position exists, one can see fast per cent increases in share price and high volume. If the short sale doesn't exist, the bubble bursts and is followed by a fast drop as the orchestrators sell out.
The 504
A "504" refers to rule 504 of Regulation D. This SEC regulation provides exemptions for companies to sell securities without having to register them with the SEC. Rule 504 entitles a company to sell up to $1 million worth of shares within a 12-month period without share registration.
These sold shares must be restricted, meaning that they can't sell for a period of time (usually one year), in order to prevent immediate dilution. But the company must un-restrict these shares and dilute at some point. Rule 504 allows a company to quickly raise money through selling shares while diluting.
Transfer Agent
Companies use transfer agents to manage shareholder records, issue and cancel stock certificates, and process investor mailings. Penny stock companies normally contract this job to specialists. Transfer agents find the most accurate information on the current outstanding shares, authorized shares and float for a penny stock. Investors desire this sort of company transparency.
If the company instructs the transfer agent not to release information, we talk about a gagged transfer agent. The company usually requests this from its transfer agent to hide dilution.
Without knowing the current number of outstanding shares, investors don't know whether the company is selling shares at the present moment, and the number of shares that can be sold is unknown as well. Companies that practice this swindle often issue news releases with excuses for gagging their transfer agent.
