Some investors may feel confident investing in well-known or famous penny stocks in the media limelight, but that attention can make them even riskier

Perhaps the most famous penny stock in history was the Bre-X Minerals Ltd. This Calgary-based company was involved in a major gold exploration scandal when it reported it had found a huge deposit in Busang, Indonesia (in Borneo). Bre-X bought the Busang site in March 1993 and in October 1995 announced enormous amounts of gold had been discovered. That sent its stock price soaring. Originally a penny stock, its share price reached a peak at $286.50 (split adjusted) in May 1996 on the Toronto exchange, with a total market cap of over $6 billion. Bre-X Minerals collapsed in 1997 after the gold samples were found to be a fraud.

While Bre-X was an exceptional case, when investor expectations are high, it pays to be skeptical and wary.

One of the three keys to our Successful Investor approach is to downplay or avoid stocks in the broker/media limelight. Here are some of the pitfalls that can crop up for investors with overhyped stocks and “famous penny stocks.”

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The third part of our three-part Successful Investor philosophy recommends avoiding stocks in the broker/media limelight. Here is a look first at all three parts

1. Invest mainly in well-established companies. These companies have an above-average chance of surviving an economic or market downturn, and thriving again when conditions improve
2. Spread your money out across most if not all of the five main economic sectors. That way, you avoid investing too heavily in any one sector that is about to go into a deeper-than-average slump.
3. Downplay or avoid stocks that are in the broker/media limelight. When stocks get too much favorable attention from brokers and the media, they often spur excessive investor expectations. When these stocks fail to live up to those high expectations, they can slump deeply. Some never recover.

Penny stocks may be promoted to seem bigger than they are—with the goal of eventually becoming famous penny stocks

Canadian penny stock promoters love to make deals, however indirect, with major, household-name companies. They find it far, far easier to sell stock to the public if, say, Barrick Gold, BHP Billiton or some other major mining company has agreed to finance exploration of their mining claims, or if Apple or Intel or some other household-name multinational has agreed to evaluate their revolutionary software or “cloud” application.

The link with a major gives them instant credibility, especially with investors who are eager to buy penny stocks.

When they get a deal with a major, promoters go to great lengths to make it seem bigger than it is. Instead of announcing that the big company has invested, say, $50,000, penny stock promoters may issue a press release that says the two companies have entered into a “multi-stage development plan”. The release may say the major has agreed to spend “up to $10 million” or whatever. It will usually provide a toll-free number or an online link for investors who wish to order the enticing brochures.

In fact, when a penny stock shoots up on the news of big-company involvement, and the property/program/revolutionary software is still in the early stages of development, it’s often a good time to sell.

The familiarity of famous penny stocks can breed excessive feelings of comfort and expectations for performance

Brokers get information from the media, investment journalists spend a lot of time talking to brokers, and company managers listen to both. A feedback loop can develop that spurs high expectations, derails criticism, and leads companies (and their investors) to make devastating mistakes.

Needless to say, lots of smart people work in the public relations and brokerage businesses. That’s why it’s a mistake to stuff your portfolio full of popular stocks these people have publicized. A high corporate profile may provide investors with a feeling of security, but it doesn’t pay them any dividends.

You may get the feeling that these are can’t-miss investments, and that it’s safe to buy and forget them. That’s exactly the wrong thing to do with famous penny stocks. Our investment advice is that your in-the-limelight holdings are the ones you need to watch most closely.

The third part of our Successful Investor philosophy helps you assess the true importance of content in the media limelight

All in all, the third element in our strategy is crucial in avoiding stock scams. These penny stock promoters focus on companies that aren’t likely to go anywhere, and merely have an indirect connection with some trend, development or industry that is getting a lot of media attention. It takes a lot more than that to create a profitable business or investment. But if you let the media hoopla taint your investment decisions, you increase your risk of blundering into a promotional stock with as much chance of success as finding the proverbial pot o’ gold.

Our third rule also applies to the way you interpret the business news. It can help you assess the true importance of news stories that are in the media limelight.

That’s especially true today, since publishing and broadcasting have never been more competitive. The reading material and video available on the Internet, much of it free, is growing much faster than the audience. This gives editors and journalists an incentive to emphasize or exaggerate the importance of news stories and trends they cover, to attract attention in the midst of today’s information deluge. This leads to more extensive and more dramatic media coverage of certain news items, out of proportion to their actual importance.

Overall, make penny stocks a small portion of your portfolio, if that

In general, penny stocks have lower trading volumes or liquidity, and this lack of liquidity means it may be more difficult to sell a stock when you want to. They also suffer from large price fluctuations, so any bit of news will cause a penny stock’s price to rise or fall.

Penny stocks should always be a small part of any diversified portfolio. You should only buy the most speculative of them with money you can afford to lose.

What factors do you use to determine if a “can’t-miss” penny stock is nothing more than an exaggerated promotion?