I don’t know about you, but I get daily email from people I don’t know advising me to buy stocks that I’ve never heard of. These missives read like research reports from professional stock market analysts profiling companies that have just developed exciting new products or services with huge market potential.

I know that these stock-hyping emails work, because occasionally I check the touted stock’s trading volume. Typically, the number of shares traded daily jumps by a factor of four or so, for days after the email. Back in November 2001, I received a particularly enticing report from a “new financial service” that said it was “striving to find investment opportunities.” I’ll call this helpful adviser Ted Touter. Ted said his analyses would save me “hours of research,” and that “each recommendation is extensively researched.”

Opportunity Knocks

Ted was plugging a company, let’s call it Miracle Tech, that was developing batteries for the automotive and electric car industries. Its mission, according to Ted, was to exploit patented and proprietary battery technology to create “the ultimate battery, characterized by superior power, higher capacity, lighter weight, and minimal acid and lead content.” You’d think that the battery project would consume the resources of most young companies, but not Miracle Tech.

The firm was concurrently developing a device to detect the presence of water in storage and fuel tanks. Wait, there’s more! Evidently grain must be dried before storing, and Miracle Tech was working on a microwave device to do just that. Even that wasn’t enough to satisfy the eager Miracle Tech scientists. The company was also designing equipment to join large diameter pipes together using a magnetic technology.

Ted expected Miracle Tech’s earnings to grow from a loss of $0.11 per share in 2001 to a profit of $0.89 in 2005. Based on these forecasts, Ted targeted a $1.80 per share stock price by the end of 2002, and $18 by the end of 2005. That amounted to a tidy 3,000 percent gain in four years, since the stock was then trading at only $0.48 per share.

Shoestring Operation

Obviously, Miracle Tech must have employed hordes of research scientists and technicians to manage the simultaneous development of those impressive products. Here’s the real miracle: Miracle Tech was doing the whole job with a staff of only 10 full-time, and two part-time employees, toiling away in a 5,000 square foot facility that it had rented for $2,000 per month.

I’m not sure how Miracle Tech managed to pay even that meager staff since, as of July 31, 2001, it had only $8,000 in the bank and its debts far exceeded its assets.

With an empty bank account, Miracle Tech must have been cranking up sales. But that wasn’t happening. Miracle Tech’s total sales in the previous 12 months totaled a flat zero. Nothing! I checked up on Miracle Tech again in March 2002, when I was writing this article. By that time the firm’s October 2001 quarterly report had been filed with the SEC. The company, with its stock now trading at 30 cents, still hadn’t sold a dime’s worth of products. But it had managed to burn through $767,000 in the quarter, mostly on consulting fees.

Miracle Tech may not have sold anything, but it had been busy cranking out press releases.

On November 6, 2001, Miracle Tech announced a partnership with a Chinese company based in Singapore to market Miracle Tech’s products. The two companies seemed most excited about Miracle Tech’s magnetic pipe joining technology.

On December 18, Miracle Tech announced the formal opening of its Beijing office, mentioned its new partnership with the Chinese company, referring to it as a “hugely significant step.” On January 30, 2002, Miracle Tech announced an agreement with a unit of the Chinese government to investigate and develop Miracle Tech’s magnetic pipe joining technology.

On February 11, 2002 Miracle said that it was in discussions with a major Middle-Eastern gas producer regarding its pipe joining process. I suppose that it’s theoretically possible for Miracle Tech and its shareholders to hit the jackpot with one of their projects. However, most companies developing products as sophisticated as Miracle Tech’s, spend tens of millions of dollars, and employ staffs numbering into the thousands.

Hyping Pays Well

How come Ted Touter didn’t see what I saw? What about all that careful research that Ted promised in his email? Reading the disclaimer at the end of Ted’s report revealed that Miracle Tech paid him to prepare and mail the report, in this case, 100,000 shares of Miracle Tech stock. It’s legal for Ted to promote Miracle Tech and to get paid for it as long as he reveals the payments in the document and confesses that Miracle Tech, in truth, supplied his so-called research. Companies like Miracle Tech hire people like Ted to create investor interest, moving the stock price up, and equally important, increasing the trading volume, thereby allowing insiders to dump their holdings. This process is known as pump and dump.

Quick Hype Checks

It’s understandable that investors get taken-in by promoters like Ted. It’s everybody’s dream to get in on the ground floor of the next big thing.

But many of the stocks you hear about from people that you don’t know are not real businesses. They’re just shells organized to sell stock to gullible investors.

Here are some simple checks you can run to spotlight the Miracle Techs of the world so that you don’t waste time researching, or worse, buying them.

You can find everything you need on almost any major financial site. I’ll use Yahoo’s Profile report to illustrate the process. Get a quote on Yahoo, select Profile, and scroll past the top section containing the business summary to Statistics at a Glance to find the data.

PRICE

Many professional investors shun stocks trading at prices below $5 per share. However, scores of fallen angel tech stocks were still trading in the $2 to $5 range in early 2002. So $1 would have been a reasonable minimum acceptable share price in that market. Miracle Tech’s $0.30 share price flunked.

MARKET CAPITALIZATION

Minimum: $50 million

Market cap is the total value of a company (shares out multiplied by the share price). Larger companies are considered safer investments than smaller companies, and those with market caps below $100 million or so are considered too risky by many investors. You will avoid most pump and dump stocks by staying above $50 million. Miracle Tech’s $9 million market cap would have easily disqualified it in that category.

PRICE/BOOK RATIO

Maximum: 25

P/B (share price divided by stockholders’ equity) is the appropriate value gauge when a company has neither sales nor earnings.

TTM SALES

Minimum: $40 million

A hallmark of pump and dump stocks is little or no sales. Most companies worth considering rack up annual sales exceeding $40 million, so avoid companies below that level. As mentioned earlier, Miracle Tech’s annual sales totaled zero.

CURRENT RATIO

Minimum: 0.6

Current ratio, a comparison of a company’s assets to its current debts, is a good measure of a company’s financial condition. A current ratio of 1.0 or higher is considered safe, but some very solid companies operate with lower ratios in the 0.7 to 1.0 range. Avoid companies with current ratios below 0.6. When I checked, Miracle Tech’s current ratio was 0.3.

Summary

Thousands of U.S. traded companies meet all five of these requirements. You can avoid these risky bets by requiring your candidates to meet at least four of the five.