Why in the world would anyone buy penny stocks? So-called penny stocks are generally those that sell for less than $5, and they are traded on exchanges such as NASDAQ or the AMEX, as well as over the counter, with prices quoted on the OTC bulletin board or in the Pink Sheets. In the latter case, companies are not required to provide audited financial statements and are not regulated by the SEC.

The penny stock market is known to be rife with fraud. Because the stocks tend to be thinly traded, and since there is little public information about the companies, scams abound. Hartley Bernstein, a lawyer who was once caught up in a penny stock scandal, these days spends his time exposing suspicious activity in the sector on his Web site, Stockpatrol.com. His view? “Penny stocks don’t trade on fundamentals.” Meaning, there are often other forces at work.

Various hedge funds, among others, have been accused of manipulating penny stocks. The SEC will not comment on ongoing investigations, but acknowledges that in the past funds like Lancer Management have been accused of participating in classic “pump and dump” schemes, as well as naked short-selling of very small cap stocks. In the latter instance, managers buy up shares of a tiny company and then conspire to promote them, often over the Internet. As the stock runs up, the fund unloads its holdings leaving holders high, dry, and broke.

Naked short-selling, which has been much in the news of late, involves a fund selling stock that it doesn’t own in expectation that the price will fall. By law the seller is supposed to “borrow” shares to cover its sales; otherwise the seller may fail to deliver the stock to the new owner. Naked short-selling is a great way to drive the price down, virtually guaranteeing a profit. Because of these and other scams, the SEC has devoted a large section of its Web site to warning investors away from penny stocks.

Why would anyone be tempted? Possibly because you are besieged day and night by hysterical e-mails and faxes that guarantee riches if you would only emerge from your stupor and buy aggressively touted issues. Any normally cautious person would find something off-putting about these approaches. But not everyone does.

Having said that, there are bona fide investors in the penny stock sphere. After all, there are legitimate companies that are just getting started, and that raise money to promote a new product or sales technique. The allure, of course, is that tiny companies have great growth potential if their business model pans out.

One believer in the penny stock arcade is Peter Leeds, who is a self-acknowledged leader in the field. Mr. Leeds publishes the Penny Stock Insider, for which he charges $195 a year and has north of 13,000 subscribers. Particularly enticing to readers is Mr. Leeds’s weekly stock picks, chosen from among thousands that he and his team sift through using a technique he calls “Leeds Analysis.”

This approach uses common sense to identify the 5% of penny stocks (by his estimate) that merit attention. Mr. Leeds’s team looks for improving financial ratios and solid balance sheets. In other words, they look for companies that may actually survive long enough to test out their business plan. They check out the managements and look into who owns the stock. Then they watch the stock, analyze the technical data, and try to determine when to jump in.

Mr. Leeds’s team claims an excellent record of picking stocks. He can point to several that have scored sizeable gains after being written up. Oplink Communications, a maker of optical manufacturing solutions that was founded in 1995, rose more than 1000% after being spotlighted by Mr. Leeds. The company listed on the NASDAQ in 2000, and is an ideal example of the virtue of finding a company early in its life.

Similarly, the Leeds group wrote up Core Molding, a company started in 1988 that is involved in molded plastics. The stock now trades on the AMEX; the Leeds group claims to have recorded a 385% gain in the stock.

For all that Mr. Leeds embraces hyperbole, he recognizes that to be convincing he has to play it straight. “I’m trying to legitimize the industry” he claims, and many of his rules attempt to do just that. For starters, he claims to have never taken a fee from any of the companies he recommends. He and his team are forbidden to trade the stocks mentioned on his site. Also, he never recommends companies listed in the Pink Sheets, but sticks instead to those with audited financial statements.

He publishes his “hot list” of recommended stocks, offering subscribers links to the companies’ Web sites and trading quotes. He keeps stocks on the list for about six months and then moves them off to make room for new ideas. He doesn’t update his projected buy and sell points but does indicate if a company remains close to the original recommendation point.

A review of his “hot list” proves that even a penny stock guru can hit a rough spot. During the period from early November to early April, Mr. Leeds made 37 stock picks; 22 are lower today; 14 higher, and one unchanged. It is true that eight of the stocks made a significant move up after the recommendation was made, before drifting lower again. In some cases, it appears that the spike up may have resulted from the recommendation. Because the stocks are thinly traded, a widely read recommendation can certainly cause a jump.

Considering the risks inherent in the penny stock arena, the outcome is disappointing. Even Mr. Leeds suggests buying a basket of such stocks, rather than rolling the dice on only one name. He also recommends playing the penny stock game only if you are in a position to lose your entire investment. Wouldn’t this advice also apply to those getting off the plane in Las Vegas?

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