Penny stocks are those securities that trade in the
over the counter market or on the pink sheets for $5.00 or less per share.
Investors also call these “Microcap Stocks.” Their characteristics include
their low price, low market capitalization, and low trading volume.
While the vast majority of penny stocks go out of
business, approximately 5% are acquired and another 5% survive by growth.
There is often a big spread between the bid and ask price, making it hard to
make money on penny stocks. For example, a 50 cent spread on a $5.00 stock
means that, excluding commissions, the stock has to appreciate 10% just to
break even. Investors are lured to penny stocks because of the high returns
on the ones that prosper.
A stock that goes from 50 cents to $5.00 increases
ten fold. It takes many Fortune 500 companies decades to achieve what a
“hot” penny stock can make in a few months.
Additionally, information is hard to come by on some
of these securities. Many of these penny stocks are not required to file
annual and quarterly reports with the SEC, since they have less than $10
million in assets and under 500 investors.
$5 is also the minimum stock price that most
brokerage firms will allow as a marginable stock.
This segment of the investment world has attracted
fraudulent activities in the past, and investors need to be extremely
careful. According to the SEC, most of the scams involve spreading false
information by a) e-mail spam, b) internet fraud, c) paid promoters, d)
boiler rooms and cold calling, and f) questionable press releases.
The SEC’s website has two examples that I would like
to share with you:
The Classic “Pump and Dump” Scheme. It’s
common to see messages posted on the internet that urge readers to buy a
stock quickly or to sell before the price goes down, or a telemarketer will
call using the same sort of pitch. Often, promoters will claim to have
“inside” information about an impending development or use an “infallible”
combination of economic and stock market data to pick stocks. In reality,
they may be company insiders or paid promoters who stand to gain by selling
their shares after the stock price is pumped up by the buying frenzy they
create. Once these fraudsters sell their shares and stop hyping the stock,
the price typically falls, and investors lose their money.
The Off-Shore Scam. Under a rule known as
“Regulation S,” companies do not have to register stock they sell outside
the United States to foreign or “off-shore” investors.
In the typical off-shore scam, an unscrupulous
microcap company sells unregistered Reg S stock at a deep discount to
fraudsters posing as foreign investors. These fraudsters then sell the stock
to U.S. investors at inflated prices, pocketing huge profits that they share
with the microcap company insiders. The flood of unregistered stock into the
U.S. eventually causes the price to plummet, leaving unsuspecting U.S.
investors with enormous losses.
Penny stocks are very risky, and in many instances
it’s more gambling than investing, but it does offer the opportunity for big
rewards. I suggest that if you participate in this market you use a large
brokerage firm. They are set up and are paid to evaluate your individual
risk levels and the appropriateness of your investments.