In this article, we're going to talk about a class of stocks that are frequently mentioned in the news, but not always completely understood. In the United States, investors often associate penny stocks with issues that are not traded on one of the more prestigious stock exchanges; but that's not the complete story.
Understanding Penny Stocks
Some investors even use the term "penny stock" in a derogatory way, meaning these particular companies are not worth holding in their portfolios. The Securities and Exchange Commission defines a penny stock as a low-priced (under $5.00), speculative security of a very small company. To the SEC, this definition holds true regardless if the stock is traded on the NYSE Euronext or an over-the-counter service such as the OTCQX or OTC Pink.
In almost all instances, the phrase typically refers to the size of a company in terms of its market capitalization, which is the total value of all common shares outstanding. It is also used interchangeably with phrases such as micro cap or nano cap stocks. In terms of size, these companies would have a total market capitalization that is under $100 million. For that reason, most investors consider these stocks as speculative or risky.
A company classified as a penny stock can also be one that is growing, but with very little cash or other assets. Since most of these stocks will trade over-the counter it doesn't take a lot of money to manipulate their prices into wild swings.
Stocks traded on the NYSE Euronext or NASDAQ are much larger companies in terms of market capitalization, so it is much more difficult for individuals, and even large institutions, to manipulate their price. There is also no SEC filing requirement for stocks traded on OTC Pink, thereby increasing the speculative nature of these securities.
There can also be a liquidity problem for investors in penny stocks since trading of these issues is not as robust as those traded on larger exchanges. Liquidity is the ability to convert an asset into cash quickly. In summary, this class of stock provides two challenges for the investor: liquidity and information.
Penny Stock Myths
Another problem is the misinformation concerning certain companies and their legends, or myths, of starting out as mere penny stocks. For example, one bit of urban legend is that Microsoft started out as a penny stock. That is simply not true.
Many less-than-honorable marketers point to charts demonstrating Microsoft started out around 9 cents per share. In reality, the company's IPO share price back in 1986 was $21. The misinformation comes from historical stock charts that have been adjusted for stock splits.
For example, if a stock started at $20 per share, but split 2:1 five times over its lifetime, the chart would show its early life at $0.63, or $20 divided by 32. Charts are created this way so potential investors can see the price it is currently trading while maintaining a historical performance perspective
There is no doubt that quality companies, with growth potential, trade right now as penny stocks. However, most investors might be better served by looking to one of the major stock exchanges for an even better opportunity.
This is a financial planning and investing e-zine that takes a skeptical approach to get-rich-quick schemes. In fact, we're often inundated with offers of penny stocks "ready to take off" nearly every day. With that as a backdrop, let's set the record straight on a couple of misconceptions:
- Trading these stocks is not the best way to learn about the workings of the stock market. There are many other less-speculative ways to learn about trading, including stock market games where the investor risks none of their money.
- While these stocks might offer the investor "excitement," that isn't necessarily a good thing.
- The potential for rewards might be greater with penny stocks, but so are the potential losses. Fast movements in short timeframes can mean losing the entire investment in just a week or two.
In fact, the SEC labels penny stocks as high-risk investments and add their concern of fraud to a list that also includes liquidity problems, and lack of financial reporting. Let's finish with a summary that separates fact from fiction:
- Fact: None of the major financial reporting networks even discuss penny stocks unless they are warning investors.
- Fact: Tips shared through email cannot possibly be any kind of bargain.
- Fact: Risk and reward go hand-in-hand. The offer of any stock with high rewards to the investor also means there is a great deal of risk involved.
About the Author - Penny Stocks