NEW YORK — THE federal government is stepping up its probe of penny-stock transactions around the United States - an investigation that many securities experts insist is long overdue. ``I don't want to shut down legitimate operations to raise new venture capital. But I have to say that I don't believe I've ever run into an honest broker of penny stocks,'' says Thomas O'Hara, chairman of the National Association of Investors Corporation in Royal Oak, Mich., an organization of individual investors.
``Penny stocks are a pure gamble. Most ... people attracted to such issues are pure gamblers,'' Mr. O'Hara says.
But Jonathan Steinberg, editor of the monthly Penny Stock Journal, defends the concept behind such speculative issues. Much of the employment gain during the 1980s came about through the small-business sector, which in part is dependent on the issuance of penny stocks for new venture capital, he says.
``Sorry that these small firms couldn't issue their new stocks through Morgan Stanley, but they couldn't,'' says Mr. Steinberg with a laugh.
Penny stocks are stock issues that are traded by telephone outside the regular market-trading system, such as the American Stock Exchange and the New York Stock Exchange. They are also not authorized for quotation on the NASDAQ over-the-counter listings, although some of the NASDAQ-listed stocks started out as penny stocks. Their prices, which can range from under $1 to $5 a share, are quoted in the ``pink sheets,'' a daily compilation of stocks published by the National Quotation Bureau, a subsidiary of Commerce Clearing House.
The main problem with penny stocks - other than the fact that in far too many cases they tend not to earn their investors any money, according to critics - is that they are thinly traded, with only one or a few brokers actually selling the stock. According to officials with the Securities and Exchange Commission, that means that unscrupulous brokers can sharply inflate the cost of the stock, without the purchaser's knowing it.
Last year SEC chairman David Ruder announced that he would make the curbing of abuses in penny stocks a priority for his agency. Federal probes into penny-stock abuses are under way in New York, California, Nevada, Hawaii, Arizona, Utah, and Colorado. Enormous sums of money have been lost in penny-stock scams in recent years.
``Buying a penny stock is based on naivet'e,'' says Robert Natale, editor of Standard & Poor's Emerging and Special Situations, a newsletter that in part deals with new stock issues. ``The penny-stock investor is hoping to hit a financial home run out of the ballpark. But what he doesn't realize is that most home-run batters strike out.''
The new issues announced by most established smaller companies, or even by big companies seeking new venture capital, are handled through well-known corporate underwriters, says Mr. Natale.
``An established underwriter has a reputation to protect, so a new issue in this case has a certain attractiveness,'' Natale says.
In the case of most penny stocks, however, little is known about the company, the broker, or the financial underwriter, he adds. STEINBERG of the Penny Stock Journal welcomes the current federal probe into unscrupulous dealers. But he draws a distinction between the dealers and the new stock issuances. Steinberg says it would be a mistake for the government to crack down on penny stocks in general, something that he believes may be occurring.
A potential investor has to gain access to all the major public financial records about a company, such as profit-and-loss statements, annual reports, and required disclosure statements, he says. A smart investor, Steinberg maintains, can then find worthwhile penny stocks that show solid growth over the years. Dunkin Donuts of America, for example, was first issued as a penny stock.
Critics such as Natale, however, note there is usually very little public information on penny stock companies.