Penny Stock, or Penny scam?  The Bad Side

First, what is a Penny Stock?  Simply a stock for which the share price is less than a dollar, although some Penny Stocks remain in that category priced as high as $3 or some cases $5.  So, what is the attraction?  What are the advantages?  What are the risks?  First, some definitions:

What is Market Cap?  Big Cap?  Small Cap?  Micro-cap?  Market Capitalization is the total market value of a company, calculated by multiplying the outstanding shares of the stock by the stock price.  A company with 20 million outstanding shares trading at $10.00 per share would have a market cap of $200 million.

What is float?  Float is the number of shares actually available for trading.  In the example above, if 5 million shares are owned by company insiders, including the employee’s stock ownership plan, etc., not available to be traded on the public market, there would be only 15 million shares in float.

Notice, how if the stock price increases sufficiently, the closely held shares (the 5 million) may become part of the float (as share owners begin to cash in)!  

Low cap companies (Penny Stocks) begin with high hopes of becoming the next giant tech or commodity company.  Customers can then buy many shares of these low-cap stock for relatively little money.  Sounds like a pretty good deal, right?  And if I buy a 2 cent stock that rises a couple of cents, why that’s a 100% return!

A common misconception hides the truth when it comes to the purchase of a Penny Stock.  Looking at a giant like Microsoft, which the record shows opened at a price less than 10 cents per share, actually began trading at $28.  The 10 cent price is the “adjusted stock price,” taking into account all the stock splits.  Don’t be fooled!  Successful companies aren’t born, they’re made, working through the ranks like all the rest.  Successful companies actually start pretty high, continually rising until they need to be split.

Additionally, investors may be attracted to Penny Stocks since there appears to be more room for appreciation and opportunity to own more stock.  A $1,000 investment that can buy 10,000 shares tells investors that a Penny stock is a sure way to increase profits.  What they miss is the downside to this argument.  A $0.10 stock can go down $0.05 and lose half its value just as easily. These Penny stocks usually do not succeed, with a high probability that the entire investment will be lost.

Big-cap stocks, capitalization > $10 billion, get most of the attention on Wall Street, where the lucrative investment banking business is. However, these represent only a small minority of publicly traded stocks, most are found in smaller classifications, where the values are.

Where do we find Penny Stocks?

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Penny Stocks are found outside the major exchanges, on OTCBB (over the counter bulletin boards) and on what are called Pink Sheets.  These are not posted daily as on the major exchanges.  Not being part of the major exchanges, these companies do not have to post financial information as do other listed companies.  That in itself increases the risk of ownership.  

How stocks are labelled means a lot in the eye of the beholder, separate from “value.”  That is, labels such as big and small are subjective and change over time. Big does not always mean less risky, but the big caps are the stocks most closely followed by Wall Street analysts.   Sure, some Penny Stock companies on the OTCBB and Pink Sheets might be good quality, and many OTCBB companies are working very hard to make their way up to the more reputable Nasdaq and NYSE. However, the flip-side is that there many good opportunities in stocks that aren’t trading for pennies. You need to understand that this is a high risk area that isn’t suitable for all investors. Be sure you do extensive research and understand what you are getting into with penny stocks.

Of utmost importance as you consider owning Penny Stocks, remember that they are much riskier than regular stocks.  What makes penny stocks risky? Four issues must be addressed if you decide to buy these securities:

a)  Lack of Information – The key we always preach is that any successful investment strategy must include enough information to make informed decisions.  Penny stock information is more difficult to find. Pink sheet companies are not required to file with the SEC and are thus not as publicly scrutinized or regulated as the stocks represented on the NYSE and the Nasdaq exchanges.

b)  No Minimum Standards – These penny stocks do not have to fulfill minimum standard requirements to remain on these secondary exchanges.  Sometimes, this is why the stock is on one of these exchanges. Once a company can no longer maintain its position on a major exchange, 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 has no such requirement.

c)  Lack of History – Many of these companies considered are either newly formed or approaching bankruptcy with a poor track record or none at all.  This lack of company history magnifies the difficulty in picking the right stock.

d)  Liquidity – Money or cash is the most liquid asset!  That means, the speed of a sale and its price are opposite sides of a coin.  If I want to sell a stock, which has a small float, the sell can reduce its price.  On the other end, to buy a (low float) stock my entry can make the price go up!  A liquid market means there is plenty of float to handle any change in volume, with no subsequent change in price.  So, the two problems that come with a low liquidity: First, it may be tough to find a buyer and you may have to lower your price to be attractive to another buyer. Secondly, low liquidity levels allow 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).

There are literally hundreds of investment boards where anyone can rant, rave, or post BS. Online bulletin boards (BBs) come in various forms, including newsgroups, usenet, or web-based boards. Some of the larger BBs, like those found on sites such as Raging Bull, Boards on Yahoo! Finance, and Silicon Investor, see thousands of messages posted on an hourly basis.  While there are many valid and useful posts on these boards, a large number turn out to be bogus. Fraudsters most often use a pump and dump scheme on BBs by pretending to reveal inside information about big upcoming announcements, great new products, or lucrative contracts. The opposite can be done too. If fraudsters hold a short position in a company, they will try to spread negative rumors in the hope that investors will panic and push prices down. 

The tricky part about BBs is anonymity. You don’t know for sure who you’re dealing with and how credible they are. People claiming to be unbiased observers who’ve carefully researched a company may actually be company insiders, large shareholders, or paid promoters. A single person can easily create the illusion of widespread interest in a small, thinly-traded stock by posting a series of messages under various aliases. 

Since Spam costs virtually nothing to create, it has become the tool of choice for many fraudsters. Often these messages consist of “get-rich-quick” schemes and offer “guaranteed results.” If the sender is unfamiliar to you or the message is addressed generally (great investment tip) it is likely a scam. Brokers and traders don’t give away good tips to random people for free. Besides, no reputable company would spam to get their name out. The smartest thing you can do is hit your delete button. Every stock pick site offers a newsletter supposedly full of useful insights and great stocks. There are many good newsletters out there, but some are just promoting stocks under the guise of presenting investors with “free unbiased information.”  We are plagued by e-mails that promote unbelievable deals daily.  It isn’t too tough to recognize these these shady e-mails.  Besides promising huge results with no risk, look for CAPITALIZED LETTERS WITH MANY EXCLAMATION MARKS!!! FOR SOME REASON SCAM ARTISTS THINK YOU’LL LISTEN IF THEY WRITE LIKE THEY ARE SCREAMING AT YOU!!! 

To recap:  Many scams on the ‘Net aren’t new at all. They’re just variations on classic Ponzi schemes, pump and dump scams, and offshore investing scams.  Bulletin boards and penny stocks are especially dangerous because you don’t know the identity of who is posting. Take all posts with a grain of salt.  Newsletters are often written by paid promoters. Always be skeptical: if things sound too good to be true, they probably are.

The Good Side

Penny stocks have a bad reputation as noted above. The media usually focuses on the negative side of penny’s, saying they are risky, frequently fraudulent and lacking in quality that investors should demand in a company. Certainly these are all valid concerns for any company, but big companies (think Enron and Worldcom) have also fallen prey to issues of internal fraud that virtually destroyed shareholder interest. Clearly, company size is by no means the only factor when it comes to investors getting scammed.

If it is only the price that is of interest, there are dozens of companies listed on the major exchanges priced below $1.00.  (As I write this post
[11/27/14], 187 in the U.S. Common Stocks category are below $1.00)  The following ticker, HH, is such an example.  All  of the caveats listed earlier still apply, this is just to identify our many choices.

Penny Stocks

Figure 1    HH (Hooper Holmes, Inc.) Low-price ticker.

So, Why Invest In Small Cap Stocks? 

When you are eyeing penny stocks, a number of positive factors weigh against some of their negative attributes. Three of the most compelling reasons why penny’s caps deserve representation in many investors’ portfolios are listed below: 

Huge growth potential – Most successful large cap companies started at one time as small businesses. Small caps give the individual investor a chance to get in on the ground floor.  Because small caps are just companies with small total values, they have the ability to grow in ways that are simply impossible for large companies. A large company, one with a market cap in the $1 billion to $2 billion range doesn’t have the same potential to double in size as a company with a $500 million market cap. At some point you just can’t keep growing at such a fast rate or you’d be bigger than the entire economy! If you’re seeking high-growth companies, small caps are the place to look.

Most mutual funds don’t invest in them.  It isn’t uncommon for mutual funds to invest hundreds of millions of dollars in one company. Most small caps don’t have the market cap to support this size of investment. In order to buy a position large enough to make a difference to their fund’s performance, a fund manager would have to buy 20% or more of the company. The SEC places heavy regulations on mutual funds that make it difficult for funds to establish positions of this size. This gives an advantage to individual investors who have the ability to spot promising companies and get in before the institutional investors do. When institutions do get in, they’ll do so in a big way, buying many shares and pushing up the price.

Penny’s are often under-recognized. This third attribute of small caps is very important. What we are saying here is that small caps often have very little analyst coverage and garner little to no attention from Wall Street. What this means to the individual investor is that, because the small cap universe is so under-reported or even undiscovered, there is a high probability that small cap stocks are improperly priced, offering an opportunity to profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market.


Should we trade penny stocks?  You’ve seen the good, the bad, and some ugly.  Before you make any entry into or with a Penny stock, you have to make some heady decisions (decisions, plural).  Like the man said, the scientific answer is always, “It Depends!

Depends on what – Who – You!  Read and study the brief items posed in this Post, see how each item fits your investment/trading philosophy, risk profile, and make a decision.  It is not a live or die decision, but a step on your own progress down the never-ending growth curve of understanding, reward, risk, fulfillment.  

And, above all…

Always use stops!