Can You Make It Big With Penny Stocks?

Browse a few investing or finance websites—even legitimate, high-profile ones like Yahoo! Finance—and you’ll see banner ads making fantastic claims about the money to be made in penny stocks. It’s perfectly understandable that you might wonder, given the prevalence of such advertising, whether there is any truth to those claims.

Penny stock websites have proliferated wildly—as you’ll discover should you choose to click any of those banner ads—and come in all flavors. Some, like Hot Penny Stocks Finder, have price boards and graphs that present an appearance that is, at least superficially, very businesslike. Others, such as the Timothy Sykes website, are longer on hype.

Of course, your first question may be, “What exactly is a penny stock, anyway?” Well, as it happens
there is no universal definition. The Securities and Exchange Commission (SEC) says a penny stock is any issue under $5.00. By that standard, no less a venerable institution than Bank of America (BAC) was a penny stock for a while back in March 2009, when it reached a low of $3.14. Some authorities set a limit of $3.00, and then there are those who insist on a technically-accurate criterion of less than $1.00.

It’s these extremely low share prices that open the door to one of the common tactics used to promote penny stocks: the very small price movements (which implies a very short timeframe) required to produce huge gains in percentage terms. At $0.20 a share, $0.04 represents a 20% change. Think about how long it would take to achieve a 20% increase in Amazon (AMZN) or Apple (AAPL) shares.

While that may sound perfectly reasonable at first blush, the same hard, cold logic that applies to the august members of the NYSE and Nasdaq applies to penny stocks. Share price should, under normal conditions, reflect the valuation of the company and its future earning potential. It will also reflect collective market activity that favors or disfavors the stock, which (arguably) can be irrational in the short term.

In other words, despite the fact that many penny stocks represent young companies, the true value of those businesses isn’t likely to change by huge leaps on the order of 10%, 20%, or 30% in a matter of days or weeks. Nor are institutional fund managers buying into the stocks in quantities that will drive a massive price swing—in fact, they aren’t buying into them at all.

So where do penny stocks come from, and where are they found? One origin of penny stocks is delisting—the removal of a company from one of the major exchanges. The NYSE, for example, has certain listing criteria, such as minimum share price and market capitalization, that it requires in order for a company’s stock to trade on its exchange. Companies that fall on hard times can “fall off” the major exchanges, landing somewhere like the Over-the-Counter Bulletin Board (OTCBB).

The OTCBB is, like the Nasdaq, a purely electronic exchange (as distinct from the NYSE, which although it uses electronic trading extensively, still has a physical trading floor in New York). However, unlike the Nasdaq, it has very little in the way of listing criteria—no minimum share price, market capitalization, or annual revenue.

The second place penny stocks are sold is the Pink Sheets. Stocks on the Pink Sheets fall below thethreshold of 300 shareholders, which is the limit at which the SEC says the company doesn’t have to be regulated. That means the public filings mandated for most public companies—filings which are available to anyone on EDGAR—aren’t required.

That leads us to the first problem with penny stocks: the near-total lack of disclosure and reliable information. The sort of transparency investors have come to expect of publicly-traded companies, thanks to SEC regulations and further legislation such as Sarbanes-Oxley, doesn’t exist in this arena.

You have no way to know much of anything about these companies, from accurate financial statements to insider holdings and trades to who actually owns or runs them. Analysts don’t follow them; if you do see an “analyst opinion” of one of these stocks, you can bet it comes from someone paid to produce that analysis—which should tell you just how reliable it is.

The earlier allusion to the fact that institutional investors don’t buy these stocks segues nicely into the second problem with penny stocks: lack of liquidity.

As an investor, you are probably accustomed to clicking the “Trade” button in your online platform and having a transaction occur nearly instantaneously. That’s because there are many buyers and sellers in the marketplace for normal stocks, not to mention market makers who are willing to absorb excess selling temporarily when necessary.

None of those things exist for penny stocks. As a buyer you are basically searching for someone who owns that stock and is willing to sell at that moment, and the same holds true when you are a seller. If you’ve ever tried to sell a car by placing a classified or Craigslist ad, you know that until someone comes along who wants it and will pay your price, you’re stuck with the vehicle.

The same holds true for penny stocks, so think about how many willing buyers you’ll find when you’re holding an issue that’s currently plunging in value. It can quite literally take days, and don’t expect to get the price you’re asking.

Penny stocks are often used in fraudulent schemes, such as the “pump and dump” classic wherein a given stock is heavily touted (at one time spam e-mails were a common method) to lure buyers in and drive up the price, at which point the scheme’s promoters sell their huge blocks of shares, sending the price into a death spiral.

Other techniques involve websites—which as mentioned in the introduction are legion—and even telephone scams featuring high-pressure sales tactics from “brokers.”

Has legitimate money been made in penny stocks? Certainly it has. As your father may have said, even a broken clock is right twice a day. But the lack of information and transparency so prevalent in this market makes an informed investment next to impossible. As the old saying goes, if you’re playing poker and you don’t know who the sucker at the table is, it’s you.