Companies whose earnings are out of sync with the rest of their industry are more likely to misreport them.
Based on research by Brian Rountree, Karen Nelson and Richard Price
What You Absolutely Need To Know About Microcap Stock Scams
- “Pump and dump” scams lure potential investors to a stock with fake news. When the investor buys at an artificially inflated price, the scam artists then sell.
- The more effective scams bundle unrealistic stock projections with seemingly credible information, including a company press release.
- Though these scams constitute fraud, the chances of an SEC investigation decrease when the spams involve a press release.
It’s called “pump and dump,” and it’s fraud. Con artists lure potential investors by deluging them with fake online news to get them to buy a particular stock. When the marks start buying at what amounts to an artificially inflated price, the scam artists sell, leaving the dupes with micro-cap stocks or cryptocurrencies whose value has collapsed.
Earlier this decade, Rice Business professor Brian Rountree joined then-Rice Business professors Karen Nelson, now at Texas Christian University, and Richard Price, now at the University of Oklahoma, in probing this type of fraud and the investors who fall for it. While the schemes vary, the researchers found that they work best when the fake news is bundled with seemingly reputable information issued by the company itself. Wildly optimistic stock price projections seem much more plausible when accompanied by a company press release.
In several respects, such cons offer a natural setting to examine what gets the attention of unsophisticated investors. To better understand this dynamic, Rountree’s team analyzed 639 unique spam events from internet archives of spam messages between January 1999 and May 2006.
Sophisticated pump and dumps generally work on two levels. First, there is the internet equivalent of boiler room con artists, people who buy a micro-cap stock, spam fake news about its prospects, then reap the rewards.
To make any kind of return on their scam, though, these grifters have to actually buy the stock in massive quantities, exposing themselves to significant risk of investigation by the Securities and Exchange Commission. They’re further hindered by a lack of access to corporate information. Hence, these kinds of spammers will more often than not generate flattering material about a stock, but aren’t likely to include corporate press release information.
The second type of scammers have some kind of relationship with corporate management. They already hold or receive shares as compensation, allowing them to profit from a rise in liquidity even if the stock price does not rise much.
In this scenario, company executives may be participants in the scam. These schemes are similar to paid advertising, to raise awareness about a company’s stock. Nevertheless, the odds of the overly optimistic projections actually coming true are equivalent to the odds of picking winning lottery numbers.
But since these messages include full disclosure of a relationship with a company, and the analysis is accompanied by caveats indicating there is no guarantee of a return, the SEC has a difficult time prosecuting such cases.
Both types of con artist usually favor attention-grabbing micro-cap stocks (those in the news and with high past returns) with relatively low transaction costs. But, the researchers found, when potential investors got spam messages conveying vague puffery attached to nothing that might be considered factual, they were less likely to buy. The lack of anything official-looking inspired at least a minimum level of discernment.
Investors were far more vulnerable to the second type of scam. When spam messages also contained actual press release information, buying increased significantly — even if the press release information was old. The presence of a press release gave the spam message an official tone that induced more people to at least consider the message, which in turn translated to more investors actually buying the stock.
Since pump and dump scams are fraud, they are a crime to be investigated by the SEC. But the researchers discovered a troubling corollary to their findings: The SEC is less likely to investigate schemes that involve press release information and the inclusion of a disclaimer, which are exactly the schemes most likely to attract investor attention.
So buyer beware. The more professional-looking the offer of free money, the more professional the scam itself.
Brian Rountree is an associate professor of accounting at Jones Graduate School of Business at Rice University.
To learn more, please see: Nelson, K. K., Price, R. A. & Rountree, B. R. (2013). Are individual investors influenced by the optimism and credibility of stock spam recommendations? Journal of Business Finance & Accounting, 40(9-10), 1155–1183.