Cheap stocks may seem attractive to novice investors, but are penny stocks a path to riches?
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Novice investors often see the value of a company in the price of its stock alone. A stock priced at $100 seems more expensive than a stock priced at $10. Simple logic suggests that it's easier to double your money if a stock at $10 goes to $20 than if a stock at $100 goes to $110.
Sometimes this thinking leads people to look for stocks with low share prices. A stock priced under $5 per share has lots of room to grow, they think. It won't take much movement in the stock's price to make a lot of money, right? Besides, with prices that cheap, you surely have lots of options, right? All you have to do is find a stock that will double or triple in value!
What are Penny Stocks?
By popular definition, a penny stock is a stock with a very low price. There's no single definition here, but the general consensus is that low-value companies, generally priced less than $5 per share and usually well below $1, qualify. In technical terms, a penny stock fails to meet certain stringent requirements to be listed on a major exchange like the NYSE or the NASDAQ. Those requirements include the share price but also specific financial standards and an average share price over a period of time.
What makes a company's stock a penny stock? The company behind the stock is risky! It might be a very small company, not worth very much money. It might have wild swings in its stock price. It might be a risky company in a very risky business. It might have loads of debt or huge tax liabilities.
You might also hear penny stocks described as micro-caps, which refers to their relatively small market capitalization). For example, one stock might sell for $0.50 a share with two million shares outstanding. The company has a market capitalization (share price multiplied by the number of outstanding shares) of only a million dollars—tiny compared to a big company like Apple or Ford, and tiny compared to a normal sized company like Corning.
Finding Safe Penny Stocks to Buy
Given these fundamental characteristics, can you find good ones to buy? By their own speculative nature and low liquidity, penny stocks are easily prone to market manipulation. For a modest investment, a malicious investor could run up the price and convince other people that the price will continue going up and sell his shares to them at inflated prices. This pump and dump scheme is all too common. There's no secret to finding, picking, or buying microcaps. There's no reliable source of any investing tips to find low-cost stocks that are guaranteed to rise in value!
You must do your research to find any good stock. Plenty of stocks are undervalued, but to prove that you must understand their business. Why is the stock price so low? Is the company struggling? What are the chances it will succeed? For penny stocks, the risks will be evident with minimal research.
How to Buy Penny Stocks
If you already have a good discount stock broker, you almost already know how to buy penny stocks. Yet because they're not traded on a standard exchange— likely instead the over the counter market (OTCBB) or the Pink Sheets—you may have to sign a special agreement or place a phone call and agree that, yes, you really know what you're doing and you accept the additional risk of probably losing your entire investment.
Don't be fooled by disreputable corners of the Internet which advertise free penny stock trading. If you're not paying a commission to trade, you're making someone else money somehow.
Are All Cheap Stocks Gambles?
The value in a stock comes from the business's intrinsic value. Can the company earn more money next year than this year? Does the company have a coherent plan to make money, and is it believable? Generally the answer is "No". If the company were really that promising, would it still be a penny stock?
Consider also risk. Can you even trust the company? If it's not meeting regulatory requirements and it's not meeting the standards of a major market exchange like the NYSE or the NASDAQ, how trustworthy is the company? If it's not filing reports with the SEC like other public companies do, how much communication do you get and how accurate is it? How much do you trust the company to treat you well as an individual investor, with a minimum-sized investment in the company?
Worse, small stocks are often subject to extreme price volatility. Some people see this as an advantage; the price of these stocks can swing 10%, 20%, 50%, 100% in a day. If you're on the winning side of that, you may enjoy it, but the losing side is no fun. (Without good information on the company's financial picture, how can you predict what will happen?)
Even if you manage to buy a cheap stock at its low point, relatively few shares trade hands every day. If you have 1,000 shares to sell but the rest of the world all together only wants 100 shares, you'll be left holding 900 shares. Even if you've made a profit of 10x on what you sold, you're still holding 900 shares. Then again, you only pay tax when you sell, so if you're holding out for huge profits, you can ride that investment until it proves itself a winner or totally goes bankrupt. (Then again again, surely you can find better places for your money.)
Some of the worst microcap stocks invest in gold and silver and oil, especially precious metal mining. These extremely volatile markets depend on commodity prices, but the value of a mine also depends on the minerals it has available and extractable. Unless you're a mineralogist, how do you expect to review the business prospects of the mine? (Are you an expert in Canadian oil fields and the government regulations around them? Who is?) Stay away from these stocks!
Though people do make money by trading cheap stocks, people also lose money. That's why you occasionally see spam for and scams involving penny stocks—investors buy low, then try to drive up demand into a frenzy and sell their own shares at the height of the frenzy. If that sounds like fraud, it is. Whenever you see cheap stocks on the rise, ask yourself why their prices are increasing. If there's no obvious business reason, you're in risky territory.
What does that have to do with value investing? Absolutely nothing.
In the absence of reliable financial information and a solid, trustworthy history of the company, investing in penny stocks is speculation. It's difficult to back up your story about what a share price may do with the kind of rigorous financial research that shows why large companies like McDonald's or Coca-Cola are much, much better investments. They have real cash flow, for example; they make actual money. You don't have to invest in the largest companies in the world to find real gems, but you do have to invest in profitable companies with real assets.
Trading Penny Stocks is Risky
There are only three ways to make money with penny stocks in 2020 or 2120, and they're all much more difficult than you think. If you're the type of investor who likes to split off a small percentage of your portfolio for risky moves—and if you can sleep at night knowing that you could double your money or lose everything—trading penny stocks can be entertaining. Remember, though: it's riskier than value investing and much, much riskier than index investing.
Unfortunately, novice investors are more likely to lose money than to get rich from penny stocks. Anyone who bends your ear about a hot insider tip is either trying to sell you on an expensive newsletter (and make money that way) or to seduce you with a pump and dump scam to raise the price so he can sell it at a profit. (This is how 900 Percent Stocks works, it appears. When you see 900percentstocks.com in comments or reviews somewhere, run the other direction; you're looking at a scam.)
Investing in an index fund that tracks the S&P 500 may seem boring, but it's a lot safer. The best penny stocks still make their money in the world of speculation: can a company recover from bankruptcy and give you a return on your investment? Unless you time things perfectly, you're in trouble. What percentage of penny stocks fail? It's unclear, but it's easy to believe that most of them do. Many businesses fail; half of all businesses survive at least five years (PDF link)—and that counts businesses better than penny stocks.
Should beginners trade penny stocks? No! Should experts? If you want to play around with a fraction of your portfolio, invest no more than 5 or 10% in penny stocks. Think of it as play money or a lottery ticket. If you lose it, you've lost it. If you gain anything, you've gained it.
Use your good judgment and invest only in things you understand. That's how to become truly wealthy, in knowledge and in money.