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Tuesday, April 13, 2010

How to spot and avoid 'pump and dump' stock scams

Before I explain what a 'pump and dump' stock scam is and how you should avoid it, a brief digression may be in order. Such scams tend to proliferate during a particular environment and state of the stock market. And we are bang in the middle of exactly such an environment.

The Indian stock market has been on a one-way ride upwards ever since the global markets changed trend from bear to bull back in March '09. Stocks in practically all sectors have moved up by leaps and bounds.

The election results in May '09 provided a major boost to the bulls. But after gaining more than 100% from the Mar '09 low of 8000 to the Oct '09 high of 17500, the Sensex has hardly progressed much in the past 6 months. At today's close of 17822, the Sensex has gained a mere 1.8% over its Oct '09 high.

Most of the index stocks and the good non-index stocks have outperformed the index and are trading at prices that are considered 'too expensive' by small investors. Many new investors have heard stories about the phenomenal gains that can be made in stocks and are itching to jump in - or have already done so.

The stage has been set for scamsters to exhibit their bag of tricks. The first stage of the scam is well hidden from the unwary public. Promoters and associates of small, unknown companies trading at low prices join hands with a group of friendly brokers and start buying up their own shares.

Since the floating stock of such companies tend to be small, a few 'buy' orders help to 'pump up' the stock's price, which starts hitting upper circuit limits. A few judicious emails to various Internet investment groups and SMS messages to individuals reveal a huge upcoming order, or a phenomenal new technological breakthrough, or 300% growth in profits in the just-concluded quarter and a likely bonus issue.

That is enough to lure hordes of small investors to place large 'buy' orders in an effort not to miss out on a fantastic multibagger opportunity. The stock continues to hit upper circuits for a few more days. That is when the 'dumping' starts.

The promoters and their friends start unloading the stocks - in small quantities initially, which get easily absorbed in the buying frenzy. Then the big unloading happens, and suddenly the stock starts to hit lower circuits right at the beginning of the trading day. Most small investors are too inexperienced to get out, and remain stuck with large quantities of stocks that soon revert back to their earlier low-price, low-volume status.

The best way to avoid getting caught in a 'pump and dump' scam is to ignore free stock tips from unknown people. If it sounds too good to be true - it usually is. If it concerns a 'penny stock' (i.e. trading below Rs 10 for a stock with a face value of Rs 10) don't give it a second look.

Even if the stock seems interesting and is trading above its face value, don't neglect to do your due diligence. Check the debt/equity ratio and the cash flows from operations. A large debt and negative cash flows from operations are a given for these 'pump and dump' stocks.

Related Post

What does the Debt/Equity ratio indicate?


satyr said...

completely agree with you sir .. infact i wonder if greenearth resources (austral) fits the bill that you just described.... post the news on the accounting scam, it appears to be a good stock to trade on with its swings within a range and the occasional upper circuit.. seems its a matter of time before the fun ends

Subhankar said...

Thanks for your comments.

There are too many stocks that have been dumped on unwary investors to be listed here. And the same story will unfortunately get repeated when the index reaches another new high.