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.

Key Takeaways

  • Penny stocks are high-risk securities with small market capitalizations that trade for a low price outside major market exchanges.
  • A lack of history and information, as well as low liquidity make penny stocks more risky.
  • Look out for scams involving penny stocks that want to separate you from your money.
  • Choosing the right penny stock means doing your due diligence and looking at the company's financials.

What Is a Penny Stock?

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. 

The term penny stock is generally used interchangeably with micro cap. 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. Anything less than $50 million is called a nano cap.

According to the Securities & Exchange Commission (SEC), any stock that trades under $5 is a penny stock. We consider any stock that trades on the pink sheets or over-the-counter bulletin board (OTCBB) to be a penny stock. 

Instead of trading on major exchanges, penny stocks trade over the counter or on the pink sheets.

What Makes Penny Stocks Risky?

The main thing you have to know about penny and micro stocks is that they are much riskier than regular stocks. Four major factors make these securities riskier than blue chip stocks.

Lack of Information

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 (NYSE) and the Nasdaq. Furthermore, much of the information available about micro cap stocks is not from credible sources.

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.

Lack of History

Many of the companies considered to be micro cap stocks are either newly formed or approaching bankruptcy. These companies 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.

Liquidity

Two problems arise when stocks don't have much liquidity. First, 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. This technique is also known as pump and dump.

Penny Stock Scams

Penny stocks have been a thorn in the side of the SEC for some time. That's because the 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 should be taken with a grain of salt. If you notice that people or companies are being paid for their services, it generally means it's a bad investment. Also, make sure 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 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.

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. This price takes all stock splits into account. By taking a look at both Microsoft and Wal-Mart, you can see the respective prices on their first days of trading were $21 and $16.50, even though the prices adjusted for splits was about $0.08 and $0.01, 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 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 $0.10 and rises by $0.05, 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 only see the upside of penny stocks, while forgetting about the downside. A $0.10 stock can just as easily go down by $0.05 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.

Choosing the Right Penny Stock

Just because they may be much riskier than your average stock, that doesn't mean you should completely avoid penny stocks. You can, after all, make some gains from these investments. So now that you know all the things you should avoid about certain penny stocks, let's go through some of the points you should consider.

As with any other investment, do your research. No one knows your situation better than you. Doing your due diligence will help you in the long run. This means you should look up everything you know about the company, the risks it comes with, as well as whether it fits into your own investment strategy. Ask yourself if the underlying business makes sense to you as an investment. Don't put any monehy into a company's stock just because someone else recommends it or because it may be the flavor of the day.

Make sure you look over any information the company offers including its financials. Are these quality statements? If the company reports its statements on time and show that the company is financially stable, it may point to a sound investment. Be sure to do some research on the entity auditing the company as well.

The Bottom Line

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.