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Penny stocks generally refer to securities issued by very small companies that trade at less than $5 per share. Penny stocks are like a house of cards: the framework is fragile and the structure can fall at any moment. Although tempting because they are so inexpensive, penny stocks are highly risky investments that tend to collapse quickly.

Raising Capital by Going Public

Capital is one of the basic requirements of every business and going public is one of the ways to raise capital. Companies raise capital from the public by selling shares to investors who in turn become a part of the company by holding shares. Companies issue shares at different stages. Some companies wait until they are very well established to go public. Shares of such companies are often oversubscribed. On the other hand, some smaller companies trying to get a foothold go public to solve capital-crunch issues. Such companies are often young and yet to prove themselves. Such young companies may yet succeed, but many start-ups raise capital and never perform. Companies issuing penny stocks belong to this category. In order to raise capital, they float very cheap stocks quoted over the counter. (For more information see How The SEC Places Rules On Penny Stocks.)

Tracing Reasons For Failure in Penny Stocks

Why should penny stocks be risker than any other security? One answer lies in the kind of stock exchanges that list penny stocks. Established stock exchanges like Nasdaq and the New York Stock Exchange have basic standards and procedures for screening companies before they will list them on their exchanges. The screening includes assessing the financial health of company, ensuring the company has a specific number of members on the board of directors, and ensuring the company has a specific number of shareholders. This screening helps protect investors.

Companies that cannot pass standard eligibility screening can resort to trading over-the-counter. The companies which are quoted on over-the-counter (OTC) systems trade on different marketplaces like OCTQB, OTCQX, and OTC Pink. While the first two marketplaces have reporting requirements to the SEC or an insurance or bank regulator, OTC Pink has no financial standards or reporting requirements. OTC Pink is also home to penny stocks.

Companies raising capital on OTC Pink can be financially distressed with no assets and no revenues. They can have poor quality balance sheets and use debt. Some of these companies may be just looking to bail themselves out by raising public money. (For more information see How To Play The OTC Pink Stocks.)

Another reason that investors often lose money in penny stocks is the lack of any reliable historical or current information about their companies. Investors can find information about regular publicly listed companies on platforms like the SEC website, finance websites, print media, free or subscription analyst reports, and other sources. In the case of penny stocks, the companies operate from behind a veil. It is usually very difficult to obtain information about the company’s operations, products, or services. In many cases the products and services are yet to be tested in the market and are thus more likely to fail. The lack of information about penny stock companies adds to the risk of investing in their stocks.

Penny stocks prices are often manipulated and do not represent a fair value. There is no stock valuation analysis by independent brokerage firms or analysts. These deals are handled by broker-dealers, who are often more interested in sealing deals than providing a good investment to investors. The brokers fix such deals over the telephone by bringing the buyer and seller together. Thus penny stock prices do not accurately reflect their company’s worth, risks, opportunities, management, business prospects, and stakes.

The lack of information and analysis makes penny stocks prone to fraud. Since these stocks have low trading volumes, it is possible for a single entity to acquire enough shares to influence the stock price. The same entity then creates an atmosphere of hype about the penny stock through marketing like direct mail, telemarketing, voice mail messages, and newsletters. When enough buyers respond to the artificial hype, the original entity sells all their shares at the high price they created though marketing. The remaining buyers are then left holding worthless stocks. The scenario is common enough that it has a name: micro-cap scam.

The Bottom Line

Investors must realize that cheap does not always translate to good. Penny stocks tempt investors because a little upside can translate into multiple gains, but the opposite can also hold. Penny stocks trade infrequently and investors can find it hard to exit, especially at desired levels. As a result of financial weaknesses, including poor regulation and screening, companies issuing penny stock tend to succumb easily to financial lows.

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