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Should You Buy Penny Stocks?

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Novice investors often look at a stock price and see the value of the company—a stock priced at $100 seems like it's more expensive than a stock priced at $10. After all, you can double your money if the stock at $10 goes to $20 but only gain ten percent if the stock at $100 goes to $110. Isn't that how successful investors made their fortunes? Betting on the right stocks then watching them double, triple, or quadruple their money overnight?

Sometimes this desire for a great stock bargain leads investors (especially beginners!) into penny stocks, also called micro caps, smallcap stocks, or stocks on the pink sheets. A stock priced under $5 per share has nowhere to go but up, right? 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 technical answer to the question what are penny stocks, but they're shares of low-value companies, generally priced less than $5 per share and usually well below $1 per share. 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.

Why might this happen? 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 it might have huge tax liabilities. The prices of stocks under $2 reflect the size of the company (including its earnings) and the likelihood of finding good stocks under $5 is small.

You might also hear penny stocks described as micro-caps, which refers to the relatively low value of the company (from micro, meaning small, and cap, short for 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.

Penny Stocks to Buy

Searching for good and safe penny stocks to buy is tricky. By their own speculative nature and low liquidity, these 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 is known as a pump and dump. Beware; 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? Most of these businesses are risky gambles, and they're obvious even after a few minutes of looking. That's why penny stocks are bad. Your research time could pay for itself.

How to Buy Penny Stocks

If you already have a good discount stock broker, you mostly already know how to buy penny stocks. There's one twist, though. 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 that you could lose your entire investment.

Don't be fooled by disreputable corners of the Internet which advertise free penny stock trading; they're most likely scams. If you're not paying a discount broker a commission, you're making someone else money somehow.

Does Buying Cheap Stocks Work?

The answer, as always, starts with the basics: 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?

You must also consider 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? It doesn't have to file quarterly and annual 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 that the company will treat you as an individual investor, with a minimum-sized investment in the company?

Worse, small stocks are often subject to extreme volatility of prices. Some people see this as an advantage, where 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 if you're on the losing side, it's no fun. (Without good information on the company's financial picture, how can you predict what will happen?)

Some of the worst microcap stocks invest in gold and silver and oil, especially precious metal mining. Not only are these extremely volatile markets, depending on commodity prices, but the value of a mine 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? Me neither.) Stay away from these stocks!

Even if you manage to buy a cheap stock at the low point of its cycle, 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 have 900 shares you can't sell, and of course you only make a profit when you sell. (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, there might be better places to put your money.)

Making Money with Undervalued Stocks

Can you make money by trading cheap stocks? Sure, people do it all the time. 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.

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

Unfortunately, novice investors are more likely to lose money than they are to get rich from penny stocks. Anyone who's bending 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? If you're not timing 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? In a word, 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.

There are only three ways to make money with penny stocks in 2016 or 2020 or 2116, 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.

Use your good judgment and invest only in things you understand. That's how to become truly wealthy, in knowledge and in money.