The Truth About Penny Stocks



There are numerous investment vehicles available to the individual investor, each with its own myths and generalizations attached. Mutual funds will always go up (aside from the times they trend downwards), government bonds are as good as gold (except when gold outperforms them like a race car does a tricycle). A property is always secure (unless it tanks completely). A  penny stock is one of these options, but unlike CDs or the money market, a greater amount of investor acumen is required to avoid these pitfalls.

What Penny Stocks Are

A company offering shares that literally cost $0.01 would have to sell a truly impressive number before being able to fund much more than a hotdog cart in this way. Penny stocks can roughly be defined as publicly traded shares that aren’t listed on the major exchanges, representing an interest in a smaller company and costing a few dollars (or under a dollar) each.


Since the companies are smaller, share liquidity is very low, and you might not be able to bail on a position that’s heading south. This also means that their “market” price is derived from a smaller number of transactions and that a relatively low level of trading can affect their quoted price significantly.


Investing in Penny Stocks


Penny stocks have something of a reputation: if you bought shares at 1c each and the price rises to 2c tomorrow, you will look like a genius. These stocks typically don’t receive the same level of media and investor attention as those of the larger companies, so their valuations aren’t as closely scrutinized. For this reason, returns can be impressive and losses dismal, although by no means all penny stocks are volatile. The key thing to remember is that you will rarely see summaries or analyses of these smaller companies on CNN. Investing in penny stocks requires a higher level of research from the individual investor.


Penny stocks can be traded through a stockbroker just like any other share, but the investor does not have the security of knowing that the company complies with the strict listing requirements. Major exchanges have been put into place for a reason. Since these stocks tend to be invisible to journalists, there’s a greater risk of fraud, misrepresentation and insider trading than with other shares. While penny stocks registered with OTCBB are required to regularly file with the SEC, these requirements are much less stringent than those of NASDAQ or the NYSE. Stocks traded through the Pink Sheets are even less regulated and should probably be avoided.


The Important Points

Some penny stocks are “shells”, meaning that they have some assets, but no business operations in the sense that goods and services change hands in the real world. Unless the company is a startup-like enterprise that can be expected to turn a profit at some point, these shells are typically too risky to bother with. Other companies are concentrated within one vertical industry, meaning that they are highly exposed – for better or worse – to changes within that industry. Other penny stock companies are highly innovative in fields like biotech or software, so they’re likely to either win big or disappear completely, and even industry experts won’t be able to predict which is more likely.


Other penny stocks are those of companies that can no longer comply with the listing requirements of a major exchange, meaning that they are probably in decline to either bounce back or crater. While this may mean that their market valuation has undershot their actual value, it could also be an indication that they really are headed for bankruptcy, and low trading volumes could mean that even a stop-loss order will be insufficient from making an investor ride the stock all the way down.


Remember the Basics


Investing in penny stocks is no different in principle from buying blue-chip shares. Research is the most important action you can take. It’s far better to get to know one company thoroughly – even if this means that you decide not to invest – than to read headline reports on half a dozen. Not putting in the work when “playing the pennies” means that you’re pretty much feeding a slot machine.


Speculative, short-term positions are a losing game for most small investors. If your intention is capital growth, your investment horizon should be at least three months and more likely a year. Real money is made through growth, not making trades as rapidly as possible. If looking at penny stocks, search for small-cap companies with unrecognized potential rather than “sexy” stocks that have already enjoyed media exposure. By the time your cab driver is talking about a company’s stock, it’s already peaked in its current cycle and the only way left is down. If you’re receiving unsolicited advertisements for penny stocks in your inbox, delete without reading.