Dale Jackson

Personal Finance Columnist, Payback Time

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The old “pump & dump” investment scam is as old as the hills, but it’s alive and well on social media.

It’s not hard to find buzz generating around a stock that has broken away from its peers – usually on new information relating to the company. Participants claiming to have gotten in on the bottom floor praise the company and encourage others to get in at the fourth, fifth and tenth floor to keep the party going.

The conversation sometimes escalates to a love-fest as investors try to validate their decisions to buy in, and the buzz turns to euphoric visions of the next Apple.

That’s when the pump and dump begins.

It usually occurs with small cap stocks because volume is low, which makes them easier to manipulate. There are fine lines between investors who got in on the fundamentals and are staying along for the ride, investors who drank the Kool-aid and believe the stock will always rise at the current pace, and those who are trying to manipulate the price higher by hyping it.

Pump and dumpers talk up the stock and look for the euphoria to reach a fever pitch before selling. One way to do that is by putting a more positive twist on second- or third-hand information, long in the public domain, and passing it off as new information.  

In some cases they will take a short position at the same time and attempt to inject cautious or negative information in the conversation. When you short a stock, you profit when the stock goes down.

When investors start dumping over-priced, over-hyped stocks, they tend to fall quickly.  

Fear of a pump and dump scam shouldn’t dissuade you from keeping a potentially lucrative position, but here are a few prudent measures you can take:       

• Place a trailing stop order to limit losses and lock in gains. Brokerages usually offer this service for free. A trailing stop is a preset level – usually ten per cent to twenty per cent – below the current trading price. The trailing price will follow the stock price up or down and trigger a sell when it is breached. If the stock is in freefall the selling price could be slightly below the order price, but losses will be limited. It’s important not to set the trailing stop too close to the current stock price because a sudden dip could trigger an unwanted sale. The more volatile the stock, the wider the gap.   
• Verify any information you find on social media on the company’s website through company filings to the Ontario Securities Commission and earnings reports. It may be a dryer read but it’s normally void of the sort of spin pumpers might attach to it. Often a company will phrase a future development in more cautious terms and mention risks to its implementation.
• While you’re at it, look at company press releases that may have boosted the stock price and cross reference the dates with price spikes. Pump and dumpers who pass along old information as new information are hoping it will have a similar impact, but it’s likely the news is already baked into the price.   
• Check independent financial analyst reports on the company. Go beyond the ‘buy, sell, hold’ recommendation and see how a professional financial analyst interprets company earnings. Analyst reports often include a section with potential risks that could help you make a more balanced decision.
• Compare trailing and forward earnings estimates with the current stock price. This is called the price-to-earnings ratio, or PE. Some smaller startup companies don’t even have earnings but a stock price often reflects a company’s ability to generate future earnings. The PE on a typical blue-chip stock is 10 to 20 times earnings. If the price of a stock is really high compared to its earnings per share, the market may have overestimated the company’s ability to turn a profit, and the current stock price may be unsustainable.