Penny-Stock Pitfalls Seen in Conolog Surge

SOMERVILLE, N.J. ( TheStreet) -- Conolog ( CNLG) shares have rocketed 110% higher over the last week on production and order announcements, but the small tech stock is a perfect illustration of why retail investors should be wary of the actions of controlling shareholders and paid-for research coverage.

Conolog investors have enjoyed substantial gains after the company, which makes communications equipment and components, said it completed field testing and started production of its GlowWorm fiber optic detector. In addition, Conolog shares rallied after it received advance orders for its PDR systems and other communications equipment valued at over $1.9 million with deliveries to be scheduled over the next fiscal year.

At face value, the recent surge in Conolog shares from a low of $1.25 on Jan. 22 to a high of $4.72 on Feb. 1 is remarkable. But it's hard for investors to get excited about a stock that has lost 99.9% of its value over the last decade on a split-adjusted basis.

That's because Conolog has approved four reverse stock splits in the last seven years, which puts its split-adjusted price north of $33,000 per share as recently as March 2000. The reverse splits may have been done to satisfy the Nasdaq's minimum bid requirement. Nasdaq issued delisting notices as recently as March and August of 2008.

The Risk of Controlling Shareholders

For investors who may still be tempted to trade on the company's recent surge, Conolog appears to be an attractive play with momentum on its side thanks to the news releases. Share volume on Feb. 1 topped 21 million as the stock nearly doubled in price, compared to the 50-day average daily volume of only 700,000.

But investing in a company with a controlling shareholder has its pitfalls, exemplified on a bigger scale by Revlon ( REV). A group of shareholders is suing 79% stakeholder Ron Perelman after the stock jumped after a surprisingly strong earnings announcement in October, just weeks after Perelman acquired nearly half the company's common shares in exchange for retiring a burdensome debt. The situation illustrates how controlling shareholders will usually get what they want, The Wall Street Journal opined this week.

As a family-owned business with a small float of only 1.91 million shares, Conolog has far more insider ownership (12.4%) than institutional (0.9%). Companies with this profile typically see prices swing due to the minuscule supply available. Robert Benou is Conolog's chairman, CEO and CFO, and Marc Benou is the company's president and COO and also serves as a director. Together, both own more than 1 million shares of Conolog.

The Benou family's ownership changes in Conolog should be more of a concern to investors. According to Insider Insights, Robert Benou has been involved in 18 separate insider transactions since February 2008, while Marc Benou was involved in four.

In the most recent transaction on Nov. 20, Robert and Marc Benou each awarded themselves with 210,000 Conolog shares. The stock awards were part of Conolog's 2009 stock incentive plan, and a total of 800,000 shares were issued to insiders. On that day, Conolog traded as low as $1.71 and as high as $1.95 before settling at $1.88.

On the same day, the company announced the $1.9 million systems contract and the stock nearly doubled in price, Conolog said in a regulatory filing that existing shareholders were offering 780,000 shares of common stock, with both Robert and Marc Benou unloading the 210,000 shares awarded on Nov. 20. Conolog shares finished trading Monday at $4.01, good for a three-month gain of more than 150%.

The Pitfalls of Paid-For Research

Conolog also benefitted from a very bullish mention by a small-cap newsletter as it announced the share reoffering. Wall Street Grand argued that if Conolog "continues to make huge strides I wouldn't be surprised to see it become a takeover target at these current prices."

"Another very bullish sign that Conolog is set to go much higher is the change in volume recently," the newsletter said. "There is no doubt that Conolog is on everyone's radar right now after seeing the volume go from only about 10,000 shares a day to over 3.5 million to close the week on Friday!"

Retail investors who read the glowing Wall Street Grand report may be tempted to chase Conolog shares higher, even after the 110% surge. But few -- if any -- likely noticed the small print at the bottom of the newsletter.

While Wall Street Grand did note that the purpose of the "advertisement" is to provide coverage and awareness for Conolog, the research company also said it was compensated $120,000 by Conolog as part of a one-year contract for the profile coverage. In addition, Wall Street Grand said that it "expects to be compensated more in the future." Multiple attempts to contact Wall Street Grand by phone were greeted with a recorded message that voicemail was unavailable before being disconnected.

Conolog did not respond to several requests by TheStreet for an interview with Robert Benou. Separate Web links to Conolog's code of conduct and code of ethics pointed to an unavailable page.

Of course, it's not unusual for penny-stock companies to pay for stock research when traditional sell-side coverage is nonexistent. However, this can present a danger to uninformed investors looking to trade on the research alone.

Tom Brakke, a Minneapolis-based registered investment advisor and consultant to investment firms, says that most investors don't realize there's a difference in paid-for research from other sell-side firms because they don't read disclosures on incentives. He argues that the critical question for investors to ask is whether the information they're offered is factual or opinion, especially when it comes to penny-stock companies that need to pay to disseminate information.

"This is questionable from the standpoint of an investor, because there's a mismatch between getting true independent, objective research and a payment structure," Brakke says. "This is a very difficult area because there are a lot of companies that want research coverage but no one will cover them. So they hope to get information out this way. The question is how objective the information is."

Brakke says investors should be particularly wary of paid-for research firms that accept and hold company stock as compensation. In those cases, a paid-for research firm has a greater incentive to work investors into a froth over a company's prospect they're covering as the firm would stand to benefit much more from an increase in share price.

While he doesn't cover penny stocks or Conolog specifically, Brakke said he is most troubled by Wall Street Grand's assertion it expects to see future compensation. "I'm glad they disclosed this," he said. "Implicit in that they're going to get more business in the future if they do right by management. In this case, doing right by management would mean getting the stock up. It shows the incentives are all out of whack."

John Welsh, a daytrader who tweets his stock trades on Twitter as johnwelshphd, takes a harsher stance against the practice, arguing that the Securities and Exchange Commission is doing a disservice to investors by allowing Conolog's paid-for research coverage tactic to go unpunished. Welsh took a short position in Conolog before covering on Wednesday.

"The SEC should be absolutely embarrassed that they let a company like Conolog pay a promoter money to suggest they are getting bought out," Welsh wrote in an email. "It's disgraceful. It's disgusting. While the SEC concentrates on the uptick rule and short sale practices, they continue to let companies like Conolog destroy the average retail investor who absolutely has no clue why a stock is moving and just buys because the stock is up. It makes me sick."

Another red flag for investors is that Conolog said that it had $465,745 in cash and cash equivalents at the end of the quarter ended Oct. 31. Meanwhile, the company paid Wall Street Grand $120,000 for a one-year research coverage contract, according to the publication's disclosure. While the benefit of the paid-for research is quantifiable for insiders, it's unclear whether shareholders would consider the cash as well-spent.

Cause for Concern

For some investors, when insiders award themselves with shares only to dump them after a stock surge on paid-for research coverage, it can leave a bad taste in their mouths.

"Watch out," Brakke warns. "If you're a shareholder, you have a situation where management and ownership overlaps. People will pay attention to Perelman and Revlon, but it's the same thing with smaller stocks that don't have a light shone on them. When they control all the levers and there isn't scrutiny that comes with an active investor community and independent research coverage, they're going to do whatever they can do for their own economic interests. Investors need to be aware of these type of things, and unfortunately a lot of them aren't."

-- Written by Robert Holmes in Boston.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider Conolog to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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