The Lowdown On Penny Stocks

The Lowdown On Penny Stocks

Successful companies are not just born, they are made and have to work their way up from the bottom through to the ranks just like every other company. Some investors believe that seeking the next "big thing" would mean scouring through many penny stocks in the hope of finding the next Wal-Mart or Microsoft. But, this strategy will prove to be very unsuccessful in the majority of cases. Please read below to find out why pinning your dreams on penny stocks can leave you penniless.

Penny Stocks 101

The terms "penny stocks" and micro-cap" stocks could be used interchangeably. Technically speaking, micro-cap stocks are usually classified as such based on their market capitiliazation where as penny stocks are looked at in terms of their price. Definitions may vary, but usually, a stock with a market cap of between $50 and $300 million is a micro cap stock. According to the SEC, any stock under $5 is considered a penny stock. Once again, definitions may vary; some people set the cut-off point at around $3, while others consider stocks trading at less than $1 to be a penny stock. I consider any stock trading on the pink sheets or the OTC to be a penny stock. Simple, right?

The most important part about penny stocks that you need to know is that they are much more riskier than traditional securities.

Make a fortune from a penny?
What makes penny stocks more risky? There are four major factors that make these securities much more risker than blue chip stocks.

1) Lack of Public information Available
One of the most important aspects to any successful investment strategy is acquiring enough tangible information to make informed decisions. For penny stocks, information is much more difficult to track down. Companies that are listed on the pink sheets are not required to file with the SEC and are thus not as publicly scrutinized or regulated as the stocks represented on the other major exchanges. Also, a lot of the information about penny stock companies are not available from credible sources. You must have a credible penny stock source.

2) No Minimum Standards
Stocks that are on the pink sheets and OTCBB do not have to meet any minimum standard requirements to stay on the exchange. In many cases, this is why the stock is on one of these exchanges. After a company can no longer maintain it's position on a major exchange, the company moves itself to one of these smaller exchanges. Even though the OTCBB does require companies to file timely documents with the SEC, the pink sheets do not have this same requirement. The minimum standards act as a safety cushion for some traders and as a benchmark for the companies.

3) Lack of History
A lot of the companies that would be considered micro-cap stocks are either newly formed or close to bankruptcy. These companies will usually have a poor track record or none at all. As you would imagine, this lack of historical information can make it extremely difficult to determine a stock's potential.

4) Liquidity
When a stock doesn't have a lot of liquidity, there can be two problems that arise: first, there could be the possibility that you will not be able to sell the stock. If there is quite a small level of liquidity, it could be hard to seek a buyer for that particular stock, and you could very well be required to lower your asking price until it would be considered to be attractive to another buy. Secondly, a low liquidity can provide opportunities for a handful of traders to manipulate the stock prices, which is done in various ways - the easiest is to obtain a large amount of stock, hype it up, and then sell it after other investors find it sexy (this is also called a pump and dump).

Penny-Baited Traps
Penny stocks have been a problem for the SEC for some time due to the lack of information available and poor liquidity which make penny stocks an easy target for fraudsters. There is a variety of scams used to steal money from the investor. The most common are:

Biased Recommendations
A few micro-cap companies will spend money on individuals that will recommend the stock to other investors, forums, T.V. and radio shows. You may receive spam email from a person you do not know, or a company that you are not familiar with. You must STAY AWAY from having any dealings with these type of shady sources. This is not the way to invest. You need a credible source with an unbiased recommendation. You must make sure that you research every company before you invest into it. You also need to make sure that the press release issued by the company is credible. Doing your homework well has saved my friends millions of dollars.

Offshore Brokers
Regulation S of the SEC permits companies selling stock outside of the U.S.A to foreign investors to be exempt from registering stock. These companies will usually sell the stock at a bargain to offshore brokers who will in turn sell them back to U.S. investors for a large profit. By cold calling a list of possible investors and providing attractive information, these dishonest brokers will use high-pressure "boiler room" sales tactics to steal money from investors to purchase the stock.

The Penny Stock Fallacy
Two common fallacies refer to penny stocks that are many of today's stocks were once penny stocks and there is a positive correlation between the number of stocks a person holds and his or hers ROI.

Investors who may have fallen into the trap of the first fallacy believe that Wal-Mart, Microsoft and many other big companies were once penny stocks that have climbed to high dollar values. A lot of investors make this error because they are viewing the "adjusted stock price," which takes into account all of the stock splits. By looking at both Microsoft and Wal-Mart, you will see that the respective prices on the first day of trading were $21 and $16.50, even though the prices adjusted for the splits it was about eight cents and one cent. Instead of starting at a low market price, these companies started higher, continually rising until they were required to be split.

Another main reason that attracts a lot of investors to penny stocks is that there is more room for appreciation and much more room for opportunity to own a lot of stock. If a stock is around 10 cents and raises by 10 cents, you will have made a 50% return. The fact that a $1k investment can buy 10k shares, convinces the traders that micro-cap stocks are a rapid, absolute way to increase profits. As long as you educate yourself on the penny stock market and receive penny stock investment advice from a credible source, you will be okay.

The Penny Stock Bottom Line
Yes, many of the companies listed on the OTCBB and pink sheets are good quality, and many of the OTCBB companies are climbing the ladder to make Nasdaq and NYSE status. But, make no mistake about it, this is a volatile and risky environment. Make sure that you do all of your research before investing any money, and also speak to the community with any questions you have. You can also join a penny stock newsletter to send you penny stocks that are sure to gain in value. Penny Stock Hot is an excellent source and I have made a great deal of profits from their advice. I wish you all smart and safe trading!