Successful companies aren't born, they're made. They have to work through the ranks like everyone else. Unfortunately, some investors believe that finding the next "big thing" means scouring through penny stocks in the hope of finding the next Microsoft or Wal-Mart. As we'll explain in this article, this is probably not the best strategy.

What Exactly Is a Penny/micro cap Stock?
In this article, we'll use the terms "penny stocks" and "micro cap stocks" interchangeably. Technically, micro cap stocks are classified as such based on their market capitalizations while penny stocks are looked at in terms of their price. Definitions vary, but in general a stock with a market capitalization between $50 and $300 million is a micro cap. (Less than $50 million is a nano-cap.) According to the Securities & Exchange Commission (SEC) any stock under $5 is a penny stock. Again, definitions can vary, some set the cut-off point at $3, while others consider only those stocks trading at less than $1 to be a penny stock. Finally, we consider any stock that is trading on the pink sheets or OTCBB to be a penny stock.

The main thing you have to know about penny/micro stocks is that they are much riskier than regular stocks. For instance, junk bonds (bonds with a rating lower than BBB) are considered a much higher risk than those of investment grade (bonds with a rating higher than 'BBB'). In the world of stocks, the equivalent comparison is penny stocks vs. blue chip stocks.

What's the Problem With These Stocks?
What makes penny stocks risky? Four major issues arise when you decide to buy these securities:

Lack of Information Available to the Public
The key to any successful investment strategy is acquiring enough tangible information to make informed decisions. For micro cap stocks, information is much more difficult to find. Companies listed on the pink sheets are not required to file with the SEC and are thus not as publicly scrutinized or regulated as the stocks represented on the NYSE and the Nasdaq exchanges; furthermore, much of the information available about micro cap stocks is typically not from a credible source.

No Minimum Standards
Stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain on the exchange. (Read What are the listing requirements for the Nasdaq?) Sometimes, this is why the stock is on one of these exchanges. Once a company can no longer maintain its position on one of the major exchanges, the company moves one of these smaller exchanges. While the OTCBB does require companies to file timely documents with the SEC, the pink sheets have no such requirement. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.

Lack of History
Many of the companies considered to be micro cap stocks are either newly formed or approaching bankruptcy. These companies will generally have a poor track record or none at all. As you can imagine, the lack of historical information magnifies the difficulty in picking the right stock.

Liquidity
When stocks don't have much liquidity, two problems arise: first, there is the possibility that the stock you purchased cannot be sold. If there is a low level of liquidity, it may be hard to find a buyer for a particular stock, and you may be required to lower your price until it is considered attractive by another buyer. Second, low liquidity levels provide opportunities for some traders to manipulate stock prices, which is done in many different ways - the easiest is to buy large amounts of stock, hype it up and then sell it after other investors find it attractive (also known as pump and dump).