Successful companies aren't born,
they're made. They have to work through the ranks like everyone else.
Unfortunately, some investors believe that finding the next "big
thing" means scouring through penny stocks in hopes of finding the
next Microsoft or Wal-Mart. As we'll explain in this article, this is
probably not the best strategy.
What
Exactly Is a Penny/Micro-Cap Stock?
In this article we'll use the terms "penny stocks" and
"micro-cap stocks" interchangeably. Technically, micro-cap stocks are
classified as such based on their
market capitalization while penny stocks are looked at in terms of
their price. Definitions vary, but in general a stock with a market
capitalization between $50 and $300 million is a micro-cap. (Less than
$50 million is a
nano-cap.)
According to the Securities
& Exchange Commission (SEC) any stock under $5 is a penny stock.
Again, definitions can vary, some set the cut-off point at $3, while
others consider only those stocks trading at less than $1 to be a
penny stock. Finally, we consider any stock that is trading on the
Pink
Sheets or
OTCBB to be a penny stock.
The main thing you have to know about penny/micro stocks is that they
are much riskier than regular stocks. For instance,
junk bonds
(bonds with a rating lower than BBB) are considered a much higher risk
than those of
investment grade (bonds with a rating higher than BBB). In the
world of stocks the equivalent comparison is penny stocks vs.
blue-chip.
What's the Problem with These Stocks?
What makes penny stocks risky? Four major issues arise when you decide
to buy these securities:
Lack of Information Available to the Public
One thing we always preach is that the key to any successful
investment strategy is acquiring enough tangible information to
make informed decisions. For micro-cap stocks, information is much
more difficult to find. Companies 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 NYSE and
the Nasdaq exchanges; furthermore, much of the information
available about micro-cap stocks is typically not from a credible
source.
No Minimum Standards
Stocks on the OTCBB and Pink Sheets do not have to fulfill minimum
standard requirements to remain on the exchange. (Read more about
these requirements
here.) Sometimes, this is why the stock is on one of these
exchanges. Once a company can no longer maintain its position on
one of the major exchanges, the company moves 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.
Minimum standards act as a safety cushion for some investors and
as a benchmark for some companies.
Lack of History
Many of the companies considered to be micro-cap stocks are either
newly formed or approaching bankruptcy. These companies will
generally have a poor track record or none at all. As you can
imagine, the lack of histories of companies only magnifies the
difficulty in picking the right stock.
Liquidity
When stocks don't have much
liquidity, two problems arise: first, there is the possibility
that the stock you purchased cannot be sold. If there is a low
level of liquidity, it may be hard to find a buyer for a
particular stock, and you may be required to lower your price
until it is considered attractive by another buyer. Second, low
liquidity levels provide opportunities for 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).
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The Problem for Investors
Penny stocks have been a thorn in the side of the SEC for some time
because micro-cap stocks' lack of available information and poor
liquidity make these groups of stocks an easy target for fraudsters.
There are many different ways these people will try to part you from
your money, but here are two of the most common:
Biased Recommendations – Some micro-cap
companies pay individuals to recommend the company stock in
different media, i.e. newsletters, financial television and radio
shows. You may receive spam e-mail trying to persuade you to
purchase particular stock (click
here for an example). All e-mails, postings and
recommendations of that kind should be taken with a grain of salt.
Look to see if the issuers of the recommendations are being paid
for their services as this is a giveaway of a bad investment and
make sure that any press releases aren't given falsely by people
looking to influence the price of a stock.
Off-Shore Brokers–
Under regulation S, the SEC permits companies selling stock
outside the U.S. to foreign investors to be exempt from
registering stock. These companies will typically sell the stock
at a discount to offshore brokers who, in turn, sell them back to
U.S. investors for a substantial profit. By cold calling a list of
potential investors (investors with enough money to buy a
particular stock) and providing attractive information, these
dishonest brokers will use high-pressure "boiler
room" sales tactics to persuade investors to purchase stock.
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Buying These Stocks
Two common fallacies pertaining to penny stocks are that many of
today's stocks were once penny stocks and that there is a positive
correlation between the number of stocks a person owns and his or her
returns.
Investors who have fallen into the trap of the first fallacy believe
Wal-Mart, Microsoft and many other large companies were once penny
stocks that have appreciated to high dollar values. Many investors
make this mistake because they are looking at the "adjusted stock
price", which takes into account all
stock
splits. By taking a look at both Microsoft and Wal-Mart, you can
see that the respective prices on their first days of trading were $28
and $25 even though the prices adjusted for splits is $0.09722 and
$0.02444 (at time of writing). Rather than starting at a low market
price, these companies actually started pretty high, continually
rising until they needed to be split. (Click
here for a spam that claims Microsoft and Wal-Mart started out as
penny stocks.)
The second reason that many investors may be attracted to penny stocks
is the conception that there is more room for appreciation and more
opportunity to own more stock. If a stock is at $0.10 and rises by
$0.05, you will have made a 50% return. This together with the with
the fact that a $1,000 investment can buy 10,000 shares convinces
investors that micro cap stock are a rapid surefire way to increase
profits. For some reason, people think of the upside but forget about
the downside. A $0.10 stock can just as easily go down $0.05 and lose
half its value. Most often, these stocks do not succeed, and there is
a high probability that you will lose your entire investment.
Conclusion
Sure, some companies on the OTCBB and Pink Sheets might be good
quality, and many OTCBB companies are working extremely hard to make
their way up to the more reputable Nasdaq and NYSE. However, there are
far too many good opportunities in stocks that aren't trading for
pennies. Most investors would be best served by avoiding penny stocks
altogether. If you can't resist the lure of micro-caps, make sure you
do all the right research and forget any preconceived notions about
the successes of penny stocks. |