Penny stocks are high-risk securities with a small market capitalization that trade for a relatively low share price, typically outside of the major market exchanges. Investors open accounts with top discount brokers who offer the high-risk investments in hopes of making the right picks.
Successful companies aren't born, they're made. Companies usually have to work their way from humble beginnings through the ranks just like everyone else. Unfortunately, some investors believe that finding the next "big thing" means scouring through penny stocks in the hope of getting a piece of the next Amazon (AMZN) or Facebook (FB). In most cases, this strategy will prove to be unsuccessful. Here's why pinning your hopes on penny stocks could leave you penniless.
What Is a Penny Stock?
The terms "penny stocks" and "micro-cap stocks" can be used 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. We consider any stock that is trading on the pink sheets or over-the-counter bulletin board (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.
What Makes Penny Stocks Risky?
Four major factors make these securities riskier than blue-chip stocks.
1. 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 Securities and Exchange Commission (SEC) and are thus not as publicly scrutinized or regulated as the stocks represented on the New York Stock Exchange and the Nasdaq. Furthermore, much of the information available about micro-cap stocks is not from credible sources.
2. No Minimum Standards
Stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain on the exchange. 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 to 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.
3. 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 poor track records or none at all. As you can imagine, this lack of historical information makes it difficult to determine a stock's potential.
When stocks don't have much liquidity, two problems arise: first, there is the possibility that you won't be able to sell the stock. 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 to 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).
Watch out for These Penny Stock Scams
Penny stocks have been a thorn in the side of the SEC for some time because lack of available information and poor liquidity make micro-cap stocks an easy target for fraudsters. There are many scams used to separate investors from their money. The most common include:
- Biased recommendations: Some micro-cap companies pay individuals to recommend the company stock in different media, such as newsletters, financial news outlets, and social media. You may receive spam email trying to persuade you to purchase a particular stock. All emails, postings, and recommendations of that kind should be taken with a grain of salt. Look to see if the issuers of the recommendations are being paid for their services as this is a giveaway of a bad investment. Also, make sure that any press releases aren't given falsely by people looking to influence the price of a stock.
- Offshore Brokers: Under regulation S, the SEC permits companies selling stock outside the U.S. to foreign investors to be exempt from registering stock. These companies will typically sell the stock at a discount to offshore brokers who, in turn, sell them back to U.S. investors for a substantial profit. By cold calling a list of potential investors (investors with enough money to buy a particular stock) and providing attractive information, these dishonest brokers will use high-pressure "boiler room" sales tactics to persuade investors to purchase stock. (For more, read What is a Boiler Room Operation?)
Two Common Penny Stock Fallacies
There are two fallacies pertaining to penny stocks that often fool investors. The first misconception is that many of today's stocks were once penny stocks and the second is that there is a positive correlation between the number of stocks a person owns and his or her returns.
Investors who have fallen into the trap of the first fallacy believe Wal-Mart (WMT), Microsoft (MSFT) and many other large companies were once penny stocks that have appreciated to high dollar values. Many investors make this mistake because they are looking at the "adjusted stock price," which takes into account all stock splits. By taking a look at both Microsoft and Wal-Mart, you can see that the respective prices on their first days of trading were $21 and $16.50, even though the prices adjusted for splits was about eight cents and one cent, respectively. Rather than starting at a low market price, these companies actually started high, continually rising until they needed to be split.
The second reason that many investors may be attracted to penny stocks is the notion that there is more room for appreciation and more opportunity to own more stock. If a stock is at 10 cents and rises by five cents, you will have made a 50% return. This, together with the fact that a $1,000 investment can buy 10,000 shares, convinces investors that micro-cap stocks are a rapid, surefire way to increase profits. Unfortunately, people tend to see only the upside of penny stocks, while forgetting about the downside. A 10 cent stock can just as easily go down by five cents and lose half its value. Most often, these stocks do not succeed, and there is a high probability that you will lose your entire investment.
The Bottom Line
Sure, some companies on the OTCBB and pink sheets might be good quality, and many OTCBB companies are working extremely hard to make their way up to the more reputable Nasdaq and NYSE. However, there are good stock opportunities out there that aren't trading for pennies. Penny stocks aren't a lost cause, but they are very high-risk investments that aren't suitable for all investors. If you can't resist the lure of micro caps, make sure you do extensive research and understand what you are getting into.