What are Penny Stocks?

I’ve Heard The Term Penny Stocks But What Exactly Are They?

Low-priced, small-cap stocks are known as penny stocks. Contrary to their name, penny stocks rarely cost a penny. The SEC considers a penny stock to be pretty much anything under $5. Most investors don’t think of sub $5 stocks trading on big exchanges like NYSE and NASDAQ when asked to describe a penny stock. Most individual investors look at penny stocks like Wall Street’s Wild West. While the gains and losses can be impressive in penny stocks, they’re not often heard about elsewhere.

Just because you don’t hear about penny stocks every day on Bloomberg, CNN or CNBC doesn’t mean that penny stocks don’t exist. Take the recent Amwest Imaging, Inc. performance:

AMWI.OB , a software company that started issuing out press releases in November of acquisitions it was making and partnerships brought on the wrath of the world’s penny stock investors. With no revenues and a “slide of hand” marketing approach, AMWI.OB dubbed investors into driving a $0 revenue generating company from 0.17 to 1.38 within 2 weeks. Unfortunately, penny stocks have also garnered a reputation as a game filled with scams and corruption. CEO of AMWI.OB declared his ownership of 138.5 million shares the day before the stock drove to its peak and subsequently “avalanched”.

Indeed, penny stocks could be your wildest ride yet as an investor.

So then, if penny stocks usually aren’t traded on normal exchanges, where can you buy them? 

How to Buy Penny Stocks

While a lot of individual investors believe that you simply should follow you instincts, this can be the demise of your portfolio and money if you are a beginner. Until you have acquired sufficient expertise about investments, especially penny stocks, it is best to spend an adequate amount of time researching. Going on your beginner’s instincts is really a great method to shed money.

Like any other stock you would buy, you can purchase shares of a penny stock through your normal stockbroker regardless of whether or not it’s listed on a major exchange. Many of the online brokers offer reasonable rates and execution timing for penny stocks. Read more here.

While sub $5 stocks listed on NYSE and NASDAQ exchanges may not typically be considered “penny stocks” per se, these stocks can provide a lot of the benefits of penny stocks without quite so much risk. These exchanges have strict listing requirements, and while they might not permit for as much of an upside as “true” penny stocks can, they tend to be a bit more reliable. Most often, “true” penny stocks trade on listing services like OTCBB and Pink Sheets.

“True” Penny Stock Exchanges 

OTCBB, or Over-the-Counter Bulletin Board, is a quotation not to be confused with Pink Sheets, which is just a quotation publisher. Stocks that trade on this exchange are quoted with a “.OB” or .ob” suffix to them. OTCBB maintains listing requirements similar to NYSE and NASDAQ although they’re less stringent than those of the bigger exchanges. For this reason alone, OTCBB has slightly added a bit of legitimacy.

Pink Sheets is a system that simply provides investors with quotation information on stocks that are registered with it. Stocks that trade “on the Pink” are always followed with a “.PK” or “.pk” suffix after their ticker symbol. Unlike the OTCBB, Pink Sheets is not registered with the SEC and does not enforce any listing requirements.

Bottom Line: Pink Sheets stocks are incredibly risky.

The Potential Profits of Penny Stocks 

“Can I have Penny Stocks for $200 please Alex.”

Answer: Volatility

Question: Why would any investor choose to put his/her money into a penny stock with all the inherent risk involved?

Since penny stocks are prone to violent fluctuations (volatility), many investors believe that they’ll “luck out” with a stock that will jump from $0.08 to $8 in two weeks. And it has happened just maybe not in two weeks.  Read enough investment message boards and you’re sure to find success stories from investors who made a mint while trading penny stocks.

Smaller Companies and start-ups that can successfully make the jump from penny stock to power stock are rare but, when you find them, they pay out can be huge. Numbers vary quite a bit in the penny stock world but investors have raked in gains over 1,000% in just a couple of weeks’ time. AMWI.OB which we mentioned earlier posted gains of nearly 950% in a two week time frame. OCNF which was the NASDAQ ticker symbol for OceanFreight, Inc. was bought out by Dryships in July 2011 posting a gain of 4,300% in 13 months.

The real trick is finding the right stock. 

Are Penny Stocks Risky and if so, Why?

Even the most legitimate of penny stocks is plagued by high risk. Two major principal reasons that risk is so inherent in penny stock investing are:

  1. Low Liquidity
  2. Poor Reporting Standards

As all investors saw recently with the “sub-prime lending market”, liquidity problems can be an enormous deal for investors. Unlike lending, low liquidity plagues the penny stocks on a daily basis with no cure in sight. Since penny stock investing is such a “niche” area, even penny stocks with low trade volumes can have an striking effect on a stock’s share price.

According to the SEC, “Penny stocks may trade infrequently, which means that it may be difficult to sell penny stock shares once you own them. Because it may be difficult to find quotations for certain penny stocks, they may be impossible to accurately price.

What this means is this: If you play with penny stocks, you could end up with a whole lot of worthless stock that you can’t get rid of.

Another factor of concern for penny stock investors is the lack of strict reporting standards for companies whose stocks trade on OTCBB or Pink Sheets. OTCBB does require that registered companies stay current with SEC filings albeit those filings are the bare minimum compared to what a traded company on the larger exchanges would have to file.

“There’s Gold in Them There Hills”

Penny stocks have proven to be a treasure trove for dishonest people since companies that are delinquent in submitting their filings to the SEC are still so accessible to individual investors. That’s one of the reasons that the SEC has taken such an active role in making sure that “Joe Investor” is protected from unscrupulous companies and individuals in the penny stock arena. Recently the tear-jerking, inspirational Notre Dame Football player/movie hero Rudy Ruettiger was busted for “pumping & dumping penny stocks. The SEC says Ruettiger founded a sports drink company called Rudy: a scheme to sell shares of the penny stock and rake in $11 million in illicit profits.

Other celebrities have been the focus of “penny stock scandals as well like rap-star/movie actor 50 cent, NBA basketball star/movie actor Shaquille “Shaq” O’Neal, pop music star and teen heartthrob Justin Beiber. For your broker to even sell you a penny stock, they’re legally required to send you a document outlining the risks of penny stock ownership. There’s a reason brokers and regulatory bodies go to such lengths to make sure that you’re not blindly investing in penny stocks.

Scammers are out there.

What’s With all the “Unsolicited” Penny Stock Emails?

Spam, for lack of a better term, sucks. It fills inboxes with garbage and junk and, chances are, if you get a decent amount of spam you’ve seen messages designed to promote penny stocks. But the spammers have hit it all. Message boards, chat rooms, discussion groups and even advertisers on legitimate websites are all home to the stuff.

It is basic common sense; you shouldn’t go out and buy a stock that’s being praised in a sketchy e-mail if you haven’t verified the source, but some people do, and scammers make millions of dollars off of unsuspecting investors. Not to tangent but my wife recently begged me to get her a pair of the “new” Nike Women’s Dunk High Heel shoes she saw on the internet. After visits to 12 shoes stores looking for them and asking salesclerks about them or where I could find them I was left with no answers. Finally, after researching some key word phrases on the internet, I found out they are China knock-offs and Nike doesn’t make a Women’s Dunk High Heel shoe. This just proves: verify everything before you buy anything.

One of the most prevalent types of penny stock scams out there is the “pump and dump.” In a pump and dump scam, the crooks in the penny stock world load up on a cheap and worthless stock, convince inexperienced investors to buy it at inflated prices (pump), and sell their shares off when the investors push the price up enough (dump).

For help on avoiding pump and dump scams, check out the SEC’s article on the subject.

How to Rub Two Pennies Together and make $1 

Now that you are aware of the “dark side” of penny stocks, how can you profit on the potential growth that they have to offer? There are three things you’ll need to look for when picking a penny stock to make sure that you don’t get stuck:

  • Underlying business
  • Financials
  • Footnotes

With penny stocks, a company’s underlying business is even more important than it is in exchange-traded stocks. Alert: Penny stock world is home to “shell” companies that are legally incorporated but don’t have any business operations. Shell companies are a great opportunity for scammers, because they easily be set up as a “pump and dump” stock.

Note: Look for companies with true, sustainable business operations and you’ll be one step closer to finding a good penny stock.

Like any stock, a penny stock’s financials are a required tool for any could-be investors. However, with penny stocks, the question is all about the quality of the financial statements.

  • Does the company file on time?
  • Who was the auditing firm?
  • Do the company’s financials look healthy?

If you can answer yes to those three questions, it’s time to stroll through the footnotes.

In almost all publicly traded companies, footnotes are an oft-overlooked. This is probably the most important part of its filings. Sure you might be able to get by without reading Microsoft or McDonald’s footnotes but miss the footnotes for a penny stock and your portfolio might move the decimal in the “total value” to the left or even drop a comma.

Since penny stocks are smaller, sometimes even just start-up companies that are more susceptible to things like related-party transactions and non-GAAP accounting oddities, do not simply pass over the footnotes for a penny stock.

In Closing: 

  • Fact: Penny stocks can be inherently risky.
  • Fact: Penny stocks can be “cover-fire” for scammers.
  • Fact: Penny stocks can make you a lot of money.

Just like when your mother would tell you “don’t climb trees, you might fall out and break your arm,” many investors simply find that the potential windfalls are well worth the risks. There’s a reason that penny stocks remain popular among a brave clique of investors: Penny stocks can deliver a very impressive return.

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