The Lowdown On Penny Stocks

Successful companies aren’t born, they’re made — and they have to work their way from humble beginnings and 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 finding the next Microsoft (Nasdaq: MSFT ) or Wal-Mart (NYSE: WMT ). Unfortunately, this strategy will prove to be unsuccessful in most cases. Read on to find out why pinning your hopes on penny stocks could leave you penniless.

Penny Stocks 101

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. Finally, 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. (For background reading on penny stocks, see [i] Wham Bam Micro-Cap Scam [/i] and [i] How To Evaluate A Micro-Cap Company [/i].)

A Fortune for a Penny?

What makes penny stocks risky? Four major factors make these securities riskier than blue chip stocks.

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 typically not from credible sources. (For more insight, see [i] Pretty In Pink Sheets [/i].)

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. (To learn more, read [i] The Dirt On Delisting [/i].)

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 ). (To learn about the importance of asset liquidity, read [i] Diving In To Financial Liquidity [/i].)

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 different ways in which scams are 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 television and radio shows. You may receive spam email trying to persuade you to purchase 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. (For more on this, read [i] Spotting Sharks Among Penny Stocks [/i].)

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 insight, check out [i] What is a boiler room operation? [/i])

The Penny Stock Fallacy

Two common fallacies pertaining to penny stocks are that many of today’s stocks were once penny stocks and 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, Microsoft 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 8 cents and 1 cent, respectively. Rather than starting at a low market price, these companies actually started pretty 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 with the fact that a $1,000 investment can buy 10,000 shares, convinces investors that micro cap stock 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 5 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.

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, the flip-side is that there are many good opportunities in stocks 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.