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As a stock investor, you may be looking for any edge you can find.
That means refining your investing strategy, examining stock sectors, reading through 10-k reports ... Then, you come across penny stocks.
Penny stocks?
The pink sheet stocks?
The stocks with the reputation of small winnings ... little regulation … and rife with scams?
Many investors have wondered about penny stocks.
In this article, we’ll break down the intricacies of penny stock investing to help you understand their advantages, disadvantages, and why you’d be better suited investing in alternative options that produce a higher return on investment.
What Are Penny Stocks?
Historically, penny stocks were considered any stock that traded for less than $1 a share — before the Securities and Exchange (SEC) changed its definition of penny stocks. Today, a penny stock is a public company that trades for less than $5 per share.
These are the stocks of small companies that sometimes trade for pennies and are considered highly speculative. Finding penny stocks to buy often requires a high-risk tolerance.
Most penny stocks trade over-the-counter (OTC) on one of the OTC Markets Group exchanges, although some trade on the New York Stock Exchange (NYSE), such as Genworth Financial (GNW), which trades at just over $4 per share.
The return on investment (ROI) for penny stocks is asymmetrical. That means that some of these small stocks end up being 10-baggers (an investment that returns 10 times its initial purchase price), or even 100-baggers (an investment that returns 100 times its initial purchase price) — such as Southwest Airlines (LUV) and Dollar General (DG).
Even Amazon was once a penny stock. In 1997, it traded for under $2 per share.
But for every Amazon or Southwest Airlines, there are thousands of penny stocks that go to zero.
3 Tiers of Penny Stock Trading
The OTC Markets Group has three tiers for penny stocks trading OTC:
OTCQX Best Market
The OTCQX market includes companies that meet the highest standards.
OTCQB Venture Market
The mid-tier is the OTCQB Venture Market, which has early and developing stage companies that are up-to-date with reporting.
OTC Pink Market
Also called the pink sheet, the OTC Pink Market includes companies with no financial or disclosure requirements. These companies are often shell companies or those that are distressed or delinquent.
Advantages of Penny Stocks
If you’re judicious, you can find companies like Amazon or Southwest Airlines that start small and end up being megacorps.
This is an appealing advantage, because many investors won’t be able to turn their $10,000 investment into $1 million by investing solely in blue-chip stocks.
If you find a promising small startup-like company in penny stocks, it could boost your portfolio returns materially. For example, it took Walmart (WMT) just 12.5 years to increase its stock price a hundredfold.
With penny stocks, there are opportunities to find undervalued companies that the stock market is either underappreciating or ignoring altogether — the biggest advantage of investing in penny stocks.
Disadvantages of Penny Stocks
With great reward comes great risk.
Penny stocks, especially those considered hot penny stocks, are highly speculative and it’s tough to choose one that will generate a return to make up for all the losses — only a few generate a return that will beat the long-term average of the S&P 500.
Given the lack of regulation and oversight, penny stocks are often susceptible to fraud and scams.
Red Flags: How to Spot Penny Stock Scams
Many penny stocks trade for pennies for a reason.
In some cases, they’re bad companies with no business model. In other cases, they are outright scams. In even more cases, many of these companies don’t make money and never will.
Here are the top three red flags to look for when considering penny stock investments.
Redflag #1: Scam-like
Many penny stock scams can be avoided by avoiding certain companies altogether, such as those:
- operating outside the U.S
- mining stocks
- those having done a reverse merger
Companies that operate offshore (outside the U.S.) do not have to register shares in the U.S. (avoiding certain regulations), but they can still sell shares to investors in the U.S.
Redflag #2: “Hot” Penny Stocks
If a company or its products are already being hyped and it’s being dubbed the next hot penny stock to buy, it might be a sign of a “pump-and-dump”.
Promoters will pump the stock price of a penny stock with the promise of a groundbreaking product to allow themselves and insiders to sell their shares at higher prices, leaving unsuspecting investors holding the proverbial bag — also known as a pump-and-dump scheme.
Along those lines, understand the difference between research and promotion. Promoters might hire writers to pen “research” on penny stocks that paints the company in a very positive light.
Redflag #3: Lack of Information
The last red flag for a penny stock is that there is virtually no available information on the company site or filed with the regulators.
The more disclosures and information they provide the better, given that more transparency makes it harder to hide fraudulent activity.
When a company is reluctant to share information about its business or managers, it could be in financial trouble (approaching bankruptcy) or involved in fraudulent or criminal activity.
Try to find information on the quality and track record of management.
For example, ask if the managers and executives had key successes or failures?
4 Alternatives to Penny Stock Investing
While there are some instances when penny stocks can be profitable, it can also be a way to lose your hard-earned money.
Here are 4 alternatives to penny stock investing — alternatives with high upside and less risk.
Option #1: Invest in Stocks
While penny stocks are technically stocks, when most people say they are investing in stocks it’s usually blue chips, such as the S&P 500 or Dow Jones Industrial Average.
The ROI on blue-chip stocks averages 10%, while even a diversified penny stock portfolio may struggle to break even.
Option #2: Invest in Options
Another alternative to penny stocks: investing in options.
The beauty of options is that they allow investors to make money no matter which way the market is moving. Investors can profit whether the market is:
- going up
- down
- sideways
Plus, they can do so with less risk and less money than buying an asset outright.
Option #3: Invest in Gold
For investors that want to allocate part of their portfolio to hedging inflation, gold can present a golden opportunity.
Whether you’re investing in gold bars or gold ETFs, gold has a proven track record of being a store of value for centuries — and it’s not going away anytime soon.
Option #4: Invest in Real Estate
Another asset class that is less risky and more profitable than penny stocks: real estate.
Did you know that since 2000, real estate has outperformed the stock market by 2 to 1 (10.71% for real estate investments versus 5.43% for stocks)? It’s true.
Plus, unlike penny stocks, you can put your hands on your real estate investment and improve its ROI yourself.
There are a number of ways to invest in real estate — even with little money. You can:
- buy a rental property
- fix and flip a house
- wholesale a house
- Focus on a specific niche of real estate industry, like mobile homes or single-family homes
- And more
The Bottom Line: Penny Stock Investing
As an investor, you can make a profit with penny stocks. But with much risk and volatility, you have a greater chance of losing your hard-earned money.
Instead, try one of the alternative investing methods mentioned in this article.
Above all else, regardless of which form of investing you choose, ensure that you’re also investing in your knowledge and education before putting your money on the line.
