Penny Stocks

Forty years ago, a penny stock was defined as a stock that traded for under one dollar. They were stocks that investors could buy for literally pennies on the dollar. Some investors still believe that a stock is only a penny stock if it trades for $1 or less.

However, the Securities & Exchange Commission (SEC) defines a penny stock as one that trades for less than $5 a share. And some investors may even take an even more liberal definition of a penny stock to include any stock that trades under $10.

Whatever definition you use, the attraction of penny stocks is easy to see. Penny stocks offer the opportunity of a high return for a relatively minimal investment. For example, an investor who bought shares of a stock that was trading for 50 cents would only need the stock to rise to 75 cents to realize a 50% profit. Some investors also love by the idea that the low cost of entry allows them to buy a large quantity of shares, further increasing their potential reward.

Many people who dabble in penny stocks are speculators, even gamblers. They are attracted to the potential reward of these stocks. They are driven by technical signals more than fundamental analysis.

All penny stock companies have some level of risk; otherwise, they would draw the attention of institutional investors. In which case, their share price would be much higher. But why are they risky? There are two primary reasons:

The Company is Not Financially Healthy - First, they are usually highly leveraged and in some cases may even be in bankruptcy. Second, they generally have a small market cap, which means the value of their outstanding shares is low. These companies can offer the potential for sensational growth, but also increase investor risk.

Think about the fundamentals that many institutional investors look for when investing in a company.

• What is the company’s debt-to-income ratio (i.e. do they have liquidity)?
• Do they have growing revenue and earnings?
• Do they have a competitive advantage in the marketplace and/or a moat that keeps competitors away?

Almost by definition, a company whose stock trades as a penny stock will fall short on the first two points. And on the last one, they may have a product that promises a competitive benefit, but for whatever reason it may not be seeded in the market yet.

Good examples of this are biotech companies. These companies may be working potentially breakthrough drugs and therapeutics. However, these companies are subject to strict regulations and must go through a series of clinical trials before turning a profit or even beginning to deliver revenue.

Potential for Fraud - However, any time investors put their money into a volatile investment, there is a high degree of risk. What can make penny stocks riskier is the potential for fraud. This can manifest itself in many forms.

An investor may learn about a company from a newsletter that promises meteoric gains. These newsletters can appear very credible. However, if you read the disclaimers, you’ll find that in many cases, the company was paying the newsletter editor for their endorsement. This should be a gigantic red flag for you because if a company was a legitimately good investment, it wouldn’t need to pay to get an endorsement.

There are penny stocks listed on the major exchanges (i.e. Nasdaq, NYSE). To be listed on one of the major exchanges, companies have to file with the Securities and Exchange Commission (SEC) and meet all their minimum filing requirements. While this can give you confidence that the company is legitimate, the fact that they are regulated removes some of the speculative nature of these stocks.

And it’s their speculative nature that makes these stocks appealing to many investors. However, “let the buyer beware” is very applicable when you look beyond the major exchanges to find a penny stock to invest in.

Penny stocks are primarily listed in two places: the Pink Sheets and the Over-the-Counter Bulletin Board (OTCBB).  The pink sheets are a compilation of daily publications by the National Quotation Bureau. The companies listed on the pink sheets do not have to file with the SEC and do not need to meet minimum filing requirements, such as submitting a recent financial report.

The penny stocks that are found on the OTCBB are still not listed on any of the major exchanges, but they do have to meet some minimum requirements. All of this means that you, as an investor, will have a lack of information. And when it comes to deciding where to invest your money, information is power.

Despite their inherently risky nature, you can make money in penny stocks. Like investing in any asset class, investors can take simple steps to minimize risk.

Limit Exposure - Most experts say an investor’s exposure to penny stocks should be no more than 5-10 percent of their portfolio. These same experts suggest, as a best practice, they limit their exposure to any individual penny stock to 1 or 2 percent of your portfolio. This reinforces a fundamental point that investors shouldn’t invest any more money in an asset class than they are comfortable losing.

Think of Penny Stocks as Short-Term Investments – If an investor profits off of a penny stock, they should look to sell and invest that money into their long-term investments. This will help to avoid losses and keep their exposure to penny stocks at a comfortable level.

Buy Penny Stocks With High Liquidity – This helps to ensure that investors can easily trade these stocks. One way to do this is to look at the average daily trading volume. Since it’s possible to own a large number of shares, it’s important to pick stocks that allow investors to sell a large number of these shares if necessary. In some cases, if the volume of a stock is only 1,500 shares a day and an investor owns over 15,000 shares, that means there aren’t enough buyers to get out of a position quickly.

Avoid Special Fees or Volume Restrictions -  Since investors will be looking to trade these stocks rather quickly, they should use a trading platform that is not going to charge special fees or put in volume restrictions. Essentially, investors need to be able to trade these stocks just like any other common stock.

Trade a Watch List Before Committing Real Dollars - An old-school tip that can help investors decide if a stock is worth your risk, particular for beginners, is to consider paper trading. This is a very simple concept where investors invest an imaginary amount of money and then track your trades without exposing actual money. This helps investors see how quickly a stock is moving and how much volume is changing hands. Many investment platforms make it easy to track your watch list.

Perform Due Diligence - It may be tempting to invest in the latest “hot stock or industry”. The penny stock industry is littered with companies that advertise the potential to make money in oil, gas, gold and other precious metals. However, if information about a company is not readily available, or if a company seems reluctant to provide that information, then it’s a sign to look for another investment.

Another good mantra to remember with penny stocks is to focus on companies where you may have some interest and/or expertise. After all, if you are a programmer, you will be much more likely to separate a tech guru’s hype from real innovation.

There are many good stock screening services available to help you find potential penny stock companies. This should not be the extent of your research, but it could help you create a quick short list in an industry that you can then individually research. Considering there are, literally hundreds of penny stock companies, having a tool that can help you uncover potential candidates can help focus your efforts.