What are Penny Stocks?
Penny Stock status is generally defined by a stock’s market capitalization. That’s an industry term for the combined value of all its outstanding shares. Companies with a small market cap, may be considered Penny Stocks.
A handier guide is to look at the actual price of the stock. The Securities Exchange Commission (SEC) defines a penny stock as any stock trading for less than $5 per share. Others lower this threshold to $3.
Personally, I’m still not pleased with this definition as it does not exclude ‘fallen angels’, of large firms traded on the power exchanges (NYSE and NASDAQ), which have fallen on hard times. During our recent recession several large firms saw their stocks tank but I’d be reluctant to consider those as true Penny Stocks.
Based on my research, the barometer I most prefer to use when identifying Penny Stocks is the market in which the stocks are traded.
In my mind, the NYSE and NASDAQ markets represent the industry’s ‘major league’ and as such, stocks traded here are not Penny Stocks, even if their values are taking a beating.
Rather, I consider the stocks still playing in the ‘minor leagues’ to be true Penny Stocks.
This minor league is defined by two markets: Over the Counter Bulletin Board (OTCBB) and Pink Sheets.
- OTCBB – a regulated trading service for small cap companies facilitated by the National Association of Securities Dealers (NASD). This market provides real time quotes, last sale prices, and sales volumes. Listing here does require some SEC reporting but less so than for the larger listings. Stocks listed here have an ‘OB’ appended to their ticker symbol.
- Pink Sheets – This is a daily publication from the National Quotation Bureau with current Bid and Ask prices. There are fewer reporting requirements to be listed here. Stocks listed here have a ‘PK’ appended to their ticker symbol. This market is named for the color of the forms on which the quotes are presented, proving some things are just as simple as they sound.
Should I Buy Penny Stocks
OK, now that I can identify them, should I buy Penny Stocks?
Based on the market definitions, you can probably deduce that Penny Stocks are riskier and more volatile as compared to the standard markets. For this reason, I personally would not endorse this type of investment for securing your long term financial nest egg.
Why are Penny Stocks considered a riskier market? Access to information is the simple answer. Reporting requirements are neither standard nor robust and these companies tend to be younger with less history to consider.
Another factor that increases the riskiness of these stocks is the market itself. The market may not be very liquid which means you may not be able to sell a stock you have purchased. And since the value of anything really boils down to what someone is willing pay for it, your value may simply ‘disappear’.
However, it may be an interesting market for dabbling with some discretionary funds. Consider it a sandbox or financial hobby room of sorts. If you hit it big, great, but you do so without risking your financial future.
Penny Stocks that Make it Big/Successful Penny Stocks
There have been some successful penny stocks. Stocks that yielded significant returns while progressing from Penny Stock to Power Stock status.
Companies such as Xerox, True Religion Apparel, Monster Beverages (formerly Hansen Natural), and Imclone all began as legitimate Penny Stocks.
The jump from Penny Stock to Power Stock is not common, but it is possible.
How to Buy Penny Stocks
In a word, you invest in Penny Stocks cautiously.
Many consider the Penny Stock landscape to be the wild west of the investing industry, with fewer reporting requirements comes less accountability, which can foster suspect behaviors.
Penny Stock watch items:
- Not all stocks begin as Penny Stocks – some companies grow and go public on one of the power markets. A popular recent example is Facebook whose IPO was $38/share with a total market cap of $104 billion. Nothing small, penny, or minor league about that launch.
- Not all stocks hyped as former Penny Stocks are as they appear. Apple and Walmart, and Intel are commonly referred to as Penny Stocks who made good. However, none of these were actually penny stocks. Some reverse engineering of splits, valuations, and inflation adjustments are manipulated for storytelling and market making purposes. Beware the hype.
- Fallen Angels are not legitimate Penny Stocks. Eastman Kodak is a common example of a former market behemoth descended from its heyday to live among the Penny Stocks. Under most interpretations this would hardly qualify as an emerging small cap.
- Penny Stocks are highly volatile. It’s simply the nature of being small. Your Pfizer stock may shift $.05 or $.08 and you may not even notice. However, a $.12 Penny Stock would be either devastated or boomtown with a similar shift.
- Pump and Dump. Shell companies may be built up through marketing efforts as the next big opportunity. However, the tactic is only intended to pump up the value so the owners can dump on the new shareholders. This tactic is a function of the lessor regulatory requirements. For this reason, the levels of inherent trust you might deploy in this market should differ from that deployed in the NYSE or NASDAQ.
- Dig into the underlying financials and footnotes. Details you might ignore if buying a large blue chip may materially impact a small company. The professionalism and auditing of the financials are as important as their health. Is this a legitimate company conducting business appropriately or a huckster playing the market?
So how do you buy Penny Stocks? I found this to be an interesting article stepping through 10 ways to trade penny stocks. Here are some of my favorites, which parallel some of the watch items above:
- Ignore the lotto-esque stories and strategies – know the market and have a plan, don’t expect windfalls simply for playing along.
- Not a hold market – small shifts in valuation have significant implications. When you take a nice gain, move on.
- Seek volume players – similar to what we reviewed above, look for stocks with an active market. The last thing you want is to be caught owning something you can’t move.
- Don’t listen to management – management is propping up their value either to stay in business or maximize their pump and dump score. Look elsewhere for your Penny Stock research. The opportunity either is or is not good irrespective of what its leaders are saying.
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Take the PS Challenge!
So is the Penny Stock market for you? During my research I found a renown Penny Stock invester is so confident in his trading system that he is essentially challenging you to become a millionaire via the Penny Stock market. He is also offering a free set of videos to help you learn and understand how to trade Penny Stocks. Check out his millionaire challenge here. Perhaps I’ll take his challenge and report back with my findings.
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