Three Reasons to Avoid Penny Stocks

Alexander Green
by Alexander Green, Chief Investment Strategist

A Note From the Editorial Director: This week, with the first installment of our new Member Mailbag feature, we start putting the You in Investment U. The Mailbag gives you the chance to ask Alex Green and our other investment experts about the financial subjects that are on your mind. Just submit your questions, and we’ll pick the best ones to feature in future editions.

This week’s question is a common one from new Oxford Club Members looking for “value” investments. Penny stocks are appealing to inexperienced investors because they’re cheap and seem to have a lot more room to rise than fall. But as Alex explains, this kind of thinking is dangerous.

- Andrew Snyder

Dear Investment U,

I am a new Oxford Club member with very little capital. Do you have anyone that would specialize in penny stocks?

Thank You,

Dana K.

Dear Dana,

Thanks for the question.

My advice on penny stocks: Stay away.

At first glance, penny stocks seem to make sense, especially for investors with less capital. After all, it’s easier for a 50-cent stock to go to $1 than for a $50 stock to go to $100, right?

No. It’s not.

Over the years, dozens of studies have shown that lower-priced stocks don’t do better than higher-priced stocks. In fact, they do considerably worse. Ironically, it’s not easier for a 50-cent stock to go to a dollar. But it is a whole lot easier for it to go to zero.

There are other reasons why making a fortune in penny stocks is easier said than done...

Three Reasons to Avoid Penny Stocks

For starters, the vast majority of tiny, unprofitable companies are such ridiculous long shots they don’t even merit your attention. Other than that:

  • Most companies offering penny stocks have little if anything in the way of profits, not to mention the first prerequisite for profits: sales.
  • Second, you could drive a cement mixer through the bid/ask spread on many of these shares. If a stock is offered at $0.30 and bid at $0.24, for instance, you’re down 20% as soon as you get your trade confirmation. (And that’s before commissions.)
  • Third, penny stocks are thinly traded and easily manipulated. You may buy a penny stock and see it zip higher, but then have trouble getting out. It’s pretty disheartening to know you can drive down the price of a stock simply by selling your own shares at market.

Beware of Penny Stock Scammers

There are plenty of outright scammers in the marketplace.

Often referred to as a “pump and dump,” a penny stock scam is when the insiders talk the stock up on one hand while bailing out like there’s no tomorrow on the other.

That’s usually because despite the great story - and make no mistake, the stories are fabulous - the company’s business prospects are usually nil.

But penny stock promoters want you to trust them, to believe in the hot tip and ensuing fortune to be made.

If you’re going to evaluate a penny stock, here’s how they’d like you to do it. By the multibillion-dollar market they intend to operate in. By the enormous profits they’ll generate when their technology is finally commercialized. By the proven reserves of the mining company operating next door. By the results of their Phase 1 trials.

By any criterion you can think of besides what the company is actually doing right now.

Because what the company is doing right now is... usually nothing.

If you insist on examining these stocks, at least take a few basic precautions.

How to Size Up a Penny Stock

Start by reading the company’s most recent quarterly or annual report. Does it have sales or earnings? What kind of debt is it carrying? How long has the company been in business? Who are the people behind it?

In other words, if you’re going to roll the dice, make sure it’s a genuine speculation, not just a mindless crapshoot... or worse.

Also, take a look at what the insiders are doing. If the insiders - the ones who can hardly contain their enthusiasm for the company’s business prospects - are dumping the stock en masse, you know all you need to know. Run.

Some will say I’m unduly pessimistic. (Penny stock promoters, especially.) And, clearly, a few successful companies did start out as penny stocks.

But for every success story there are at least 100 penny stocks whose charts bear an uncanny resemblance to the last flight of the Hindenburg.

In short, there are plenty of smart ways to invest your money. Toying with penny stocks and expecting to bank a fortune, in my view, is not one of them.

Good Investing,

Alex

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