The U.S. Securities and Exchange Commission (SEC) defines a penny stock as a "low-priced (below $5) … speculative security of very small companies." Penny and micro-cap stocks trade on mini-exchanges that are loosely referred to as "junior markets" or "junior listings." These markets are typically hosted by larger exchanges and rarely have physical locations, relying mostly on online brokerage platforms to service investors. They play an important function in financial reporting; depending on the exchange and overarching regulatory body, it may not be mandatory for small-cap firms to report even their basic financial statements.

Penny Stock Risk
Because of the nature of the penny stock market, potential investors should beware: penny stocks are notorious for the relative opaqueness of their issuing companies as well as for the many cases of fraud within the market. An investment in a penny stock is intrinsically speculative in nature and highly risky. Famed trader Nassim Taleb championed penny stocks for their high upside, however, citing their lower valuations as an opportunity for investors to capitalize on black swan events as opposed to being destroyed by exposure to them. While some penny stocks certainly have this kind of upside, most are toxic and extremely dangerous investment vehicles. Investors should proceed with caution.

On the whole, start-up companies are desperate for more reputable junior markets and listings that will grant their ownership shares legitimacy and inspire investment and active trading. Quite simply, issuing companies want these items to be fulfilled so they can quickly and easily raise equity capital. Enter the TSX Venture.

Not Just Any Venture
The TSX Venture Exchange is a Canadian-based junior listings market that houses many micro-cap and small-cap firms. This exchange provides start-up firms the opportunity to raise equity capital and is owned by the TMX Group, a conglomerate financial services firm that primary deals in trading and clearing. The TMX Group acts as either a parent company or holding company for the Toronto Stock Exchange (TSX), TSX Select, the Equicom Group Inc. and Shorcan Brokers Inc., among other subsidiaries and companies that TMX Group has taken an ownership interest in. Out of these, the Toronto Stock Exchange is most notable; the exchange was founded in 1861 and is the foremost exchange in all of Canada, as well as being worldwide leader in the mining and energy sectors.

Until September 2012, the TMX Group itself traded on the Toronto Stock Exchange; however, it was acquired by TMX Group Limited (previously known as the "Maple Group Acquisition Corporation") on Sept. 14, 2012, and its shares were taken off the market. Today, you can trade shares of TMX Group Limited on the Toronto Stock Exchange under ticker symbol "X." The TMX Group is a highly successful company with reported operating revenue of $167.5 million in the second quarter of 2012, up from Q1 operating earnings of $162.3 million.

An Attractive Offering Indeed
As noted above, the TSX Venture Exchange is a subsidiary of TMX Group. The exchange benefits from this arrangement by being viewed favorably in the marketplace, based off the sterling reputation of the parent company. Thus, many qualifying companies were interested in applying for a listing. Other exchanges such as the OTC Markets Group Inc., known as the "Pink Sheet stocks," suffer from poor reputations of defrauding and misinforming their clients.

The different types of fraud on the penny stock market are varied and insidious. One such scheme is the "pump and dump" operation, where either the issuing company or a third party will do all it can to artificially prop up the price of its equity on the market. Then, when the stocks are sufficiently "pumped" up, the outside party will quickly liquidate its position and "dump" its entire holding back onto the market. Penny stock companies have even been known to pay celebrities to promote their equity offerings; most famously, 50 Cent's endorsement of a small penny stock firm on Twitter allowed him to cash out some millions richer when his Twitter followers took the bait.

Relative to other listings, the TSX Venture Exchange provides a high level of transparency for investors. Similar to the Toronto Stock Exchange, the TSX Venture Exchange is well regulated by the Alberta Securities Commission as well as other provincial securities regulators. Companies that are listed on the exchange must report their quarterly financial statements and interim MD&A, annual financial statements and MD&A, an annual report, etc. All in all, the TSX Venture is a better-regulated and comprehensive source of information for investors seeking to trade penny stocks. The exchange's high standards keep the good guys in and the bad guys out.

Not for Everyone
Despite the appeal of the TSX Venture offering, an investment in penny stocks is not for every investor. Although the TSX Venture Exchange may be a better penny stock exchange than most, it is better to have previous knowledge of the industries that you are investing in. Information provided by the issuing company may not be satisfactory to make sound investment decisions upon.

In addition, penny stocks are not for those who can't afford to lose big. The risks inherent to a penny stock are massive. As an inherently speculative investment, capital allocation to an investment vehicle classified as a penny stock is only for investors with the proper time horizons, liquidity needs and time preferences.

The Bottom Line
In the words of Burton Malkiel, there are not very many $100 bills lying around to be picked up. Most of the time, something that sounds like too good to be true probably is. Investors should be wary of the associated risks of penny stocks as well as the many dangers of fraud. That being said, the TSX Venture Exchange is a very legitimate enterprise - on par with the Nasdaq Smallcap Market and the American Stock Exchange (AMEX) in the U.S. Penny stock investments should only be made, by properly informed investors, with an exchange that has the standards of the TSX Venture.

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  1. Do penny stocks trade after hours?

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  3. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
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