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Penny Stocks

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.

 

 

 

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