Penny Stocks 101

Investing in Very Low Cost Shares

Penny Stocks 101
August 18, 2014

Penny stocks, as defined by the Securities and Exchange Commission (SEC), are stocks issued by small companies that trade outside of the standard exchanges such as NYSE or NASDAQ for low share prices, typically less than $5. Others define the limit as less than $1. Generally, the issuing companies have a much smaller market capitalization than companies on these exchanges and limited financial information.

The popular definition is sometimes expanded to include private company securities, larger company stocks that have taken calamitous tumbles, and other securities that are trading at low per-share prices. They are sometimes politely called microcaps for the lower market capitalization and less politely called junk stocks for reasons you can guess – representing anything from unproven companies trying to establish products and services to outright sham corporations.

People find penny stocks appealing for the same reason as lottery tickets. They give the appearance of limited investment with potentially big return, and they appeal to those who are swayed by such an argument without thinking of the odds.

The SEC issues frequent warnings on penny stock “pump and dump” schemes, where the stock price is artificially inflated – see CYNK Technology Corp (CYNK) as a recent alleged example. However, worthwhile companies have emerged from penny stocks, such as Monster Beverage Corporation (NASDAQ: MNST) and Pier 1 (NYSE:PIR), which rose from near-death to recover NYSE status.

Is there a spot for penny stocks in your investing portfolio? There can be… if you want to include them as part of the high-risk component of your portfolio. Trying to time these stocks is highly unwise – even if you did time things correctly-- because of the lower volume of trade, there is no guarantee you will find a buyer when you want to sell (or vice versa). The best way to make money is to look for a promising company with some revenue stream and a good case for future growth or a reclamation project that shows signs of recovery.

Look for the same fundamentals you would for any stock – cash flow, debt, earnings/losses and sales – as well as strategic elements like new product introductions, competitive position, patents, and growth strategy. Even at low prices, you should find a compelling reason to expect the price to go up before you buy.

Even though penny stocks are traded on the over the counter bulletin board (OTCBB) or so-called “Pink Sheets” at Pink OTC Market LLC, you can buy penny stocks through your brokerage just like you can any exchange-traded security. Because of the low value of penny stocks, choose flat-rate brokers and avoid per-share trading fees. You may have to sign a form acknowledging that you understand the unusual risks involved.

It is doubly important to do your homework when selecting penny stocks, because reliable information may be hard to come by. Any e-mail solicitation you receive about the hottest new penny stock will probably deliver results about the time you receive that multi-million-dollar check from Nigeria.

Check the SEC website for any red flags on the issuing companies and look over the information available at the OTC Bulletin Board and OTCMarkets websites. OTCMarkets features stocks listed with the highest levels of relative transparency and information (OTCQX and OTCBB) – historically they listed OTC stocks with up to eight different disclosure levels, including the lowest level of “Caveat Emptor” (that is not a joke).

Making money in penny stocks is difficult, and it is not for the novice. It is best to treat penny stocks with the same guilty pleasure and expectations of a lottery ticket – or you could just buy a lottery ticket, instead.

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