The terms “penny stocks” and “micro-cap stocks” can be used interchangeably, although, technically, micro-cap stocks are classified by market capitalization while penny stocks are classified by price. Generally speaking, a stock with a market capitalization between $50 and $300 million is a micro-cap with those less than $50 million considered a nano-cap. According to the Securities & Exchange Commission (SEC) any stock under $5 is a penny stock. Many of these are stocks under 1, hence the term penny stock. Any stock currently trading on the Pink Sheets or OTCBB can be considered a penny stock. Penny/micro stocks are much riskier than regular stocks.
The Challenges Associated with Buying Penny Stocks
Penny Stocks Challenge #1: Lack of Readily Available Information
The key to any successful investment strategy involves copious amounts of research in order to acquire enough tangible information to make informed decisions rather than take blind risks. For micro-cap stocks, reliable information is much more difficult to find, making this vital step that much more challenging. Companies listed on the pink sheets are not required to file with the SEC and do not undergo the same level of public scrutiny or regulation as the stocks represented on the NYSE and the Nasdaq exchanges. Furthermore, much of the information available about micro-cap stocks comes from unreliable sources.
Penny Stocks Challenge #2: No Minimum Standards
Stocks on the OTCBB and Pink Sheets are not required to fulfill minimum standard requirements to remain on the exchange. Sometimes, this is the very reason the stock is on one of these exchanges in the first place. Once a company can no longer maintain its position on one of the major exchanges, the company is forced to move to one of these smaller exchanges. While the OTCBB does require the filing of timely documents with the SEC, the Pink Sheets has no such requirement. These minimum standards act as a safety cushion for some investors and as a benchmark for some companies to safeguard against risk.
Penny Stocks Challenge #3: Lack of History
Many of the companies considered stocks under 5 are either newly formed or approaching bankruptcy, neither of which offers a positive background. These companies will generally have a poor track record or none at all.
Penny Stocks Challenge #4: Liquidity
When stocks don’t have much liquidity they present two problems. First, there is the possibility that the stock you purchased cannot be sold because with a low level of liquidity, it may be hard to find a buyer which forces you to lower your price until it is considered attractive enough. Second, low liquidity levels provide opportunities for some traders to manipulate stock prices in well known scams like the famous “pump and dump” featured in an early Sopranos episode. This scam involves a trader buying large amounts of stock, hyping it up (pump) and then unloading it after other investors have increased its value (dump).
Penny stocks have troubled the SEC for some time because their lack of available information and poor liquidity make penny stocks easy targets for fraudsters.
Although scammers come up with new and creative strategies to rip off investors every day, here are two of the most common scams.
#1: Penny stocks scams often start with biased recommendations. The key to all research, whether historical or financial is simple: consider the source. Some micro-cap companies pay people to recommend their penny stocks across different media like newsletters, financial television and radio shows. All e-mails, postings and recommendations trying to persuade you to purchase particular stocks should be treated as scams/spam. Conduct your own research if recommendations are sponsored since this is a telltale sign of a bad investment. Make sure that any press releases aren’t given falsely by people looking to influence the price of a stock; follow the money.
#2: Some off-shore brokers may sell penny stocks above their worth. The SEC permits companies selling stock outside the U.S. to foreign investors to be exempt from registering stock, so, these companies will typically sell the stock at a discount to offshore brokers who, in turn, sell them to U.S. investors at a substantial markup. By cold calling a list of potential investors with attractive information, these dishonest brokers will use high-pressure “boiler room” sales tactics to pressure investors to buy what should be stocks under 5.
Beware two common, but, false rumors frequently spread about penny stocks.
First is that many of today’s stocks were once penny stocks and, secondly, is that there is a positive correlation between quantity of stocks owned and their returns.
Some investors falsely believe Wal-Mart, Microsoft and other business juggernauts were once penny stocks that have now appreciated to high dollar values. This mistake is often due to focusing solely on the “adjusted stock price,” which takes into account all stock splits. For both Microsoft and Wal-Mart, 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 (as of March 19, 2018). Rather than starting at a low market price, these companies actually started pretty high, continually rising until they needed to be split.
As for the second fallacy, it’s an easy assumption that the low price of penny stocks means one can purchase many shares with low investment capital for a huge profit. If a stock is at $0.10 and rises by $0.05, this yields a 50% return; there is a downside many neglect. A $0.10 stock can just as easily go down $0.05 losing half its value, leaving you at a loss. Most often, stocks under 5 do not succeed; this high risk is the reason behind high rewards, not the low share prices.
Not all penny stocks are created equal and some companies are working harder than others to get ahead.
There are stocks under 5 you can find on OTCBB and Pink Sheets which are working extremely hard to make their way up to the more reputable Nasdaq and NYSE. However, buying penny stocks is a high risk choice that isn’t suitable for all investors. If you can’t resist the lure of stocks under 1, do extensive research and acknowledge even that doesn’t remove all risk.