Penny stocks are tricky. Some penny stocks have had great success. Most, though, have floundered or completely disappeared from the market. Picking a winning stock is never easy, but, when that winner is a penny stock, the gains can be enormous. And, when picking a loser, it’s usually the sort of loser that costs you nearly your entire principal.
Although penny stocks offer great prosperity to some, the vast majority of people will not hit a big winner when they choose to invest in a penny stock. In fact, the exact opposite can routinely be true. Penny stocks are often easy targets for market manipulation tactics, and they can often lack the transparency or available data and research one gets with larger companies.
But despite the many dangers associated with them, penny stocks are on the rise again. In the end, the biggest potential for gains lies in the largest risks, and penny stocks are some of the riskiest options out there.
What is a Penny Stock?
There is no generally accepted definition of a penny stock. When people think of penny stocks, they immediately think of a stock price trading at a few dollars or less per share ($5 per share is the generally accepted limit). It’s true that penny stocks generally trade at a very low price per share, but all stocks that trade with low share prices are not penny stocks.
For example, Las Vegas Sands (LVS) was trading at $2 per share in 2009 after The Great Recession, but most traders never considered it a penny stock. Penny stocks generally do trade under $5 per share, but also usually trade outside of major market exchanges and have a low market capitalization (the total market value of the company).
Also, penny stocks are generally regarded as highly speculative and highly risky due to a large bid-ask spread. The bid-ask spread is the difference between the lowest price a seller is willing to sell and the highest price a buyer is willing to buy. For example, if the seller asks for $21 but the buyer is only willing to pay $20, then the bid-ask spread is $1.
Generally speaking, small-cap stocks and especially penny stocks have high bid-ask spreads because they lack what stock traders refer to as “liquidity.” This means there are not a lot of shares trading hands daily.
Low Liquidity Can Make Trading Difficult
For a highly liquid stock, like Bank of America (BAC) , 60 million shares trade hands every day, on average. That means there are lots of buyers and sellers at any given point in time and the bid-ask spread is very small. With millions of transactions a day, people buying and selling the stock have a clear sense of the fair market price. Essentially, higher volume of shares traded daily equates to a lower bid-ask spread and a lower bid-ask spread also helps promote more liquidity.
But potentially the most important thing about liquidity is that it means there’s a consistent market for the stock. It’s easier to convert shares of a highly liquid stock into cash at any given moment because there’s usually a myriad of options for buyers. For a stock like Bank of America, the bid-ask spread is small as there’s always another buyer available, so there’s hardly ever much reason to accept any price significantly lower than the market price.
And, with such a small bid-ask spread (usually just a penny a share), “crossing the spread” isn’t so painful. Crossing the spread for a seller means accepting a buyer’s lower bid price instead of getting your higher ask price. It’s not ideal, but if you need to get a sale done it may be necessary. For a highly liquid stock, it’s usually a pretty marginal expense. But, for a thinly-traded penny stock with a larger bid-ask spread, it can really cut into profits or expand losses.
Depending on your situation, you may be able to wait it out until a better buyer comes along. But, if you really need to sell, the lack of liquidity may leave you with few good options. It’s an additional risk that doesn’t exist for most stocks trading on a major exchange.
OTC vs. Major Exchanges
As mentioned earlier, penny stocks trade primarily on Over the Counter markets (OTC). An OTC market is a decentralized market (there is no central physical location) where participants trade with one another. There is a range of transparency for stocks trading in OTC markets.
For example, OTC Markets Group (OTCM) is the primary American source for OTC trading and features three distinct tiers to categorize the stocks that trade on its markets for potential investors. Stocks that trade over OTCQX, OTC Markets’ top tier, must comply with reporting requirements from the SEC and are considered fairly transparent, even including shares of some mega-cap foreign companies that don’t trade on the NYSE or Nasdaq, including Roche (RHHBY) and Volkswagen ($VLKAY).
Adverse Selection
One of the biggest problems with penny stocks and companies traded in OTC markets, though, is the adverse selection that exists on the lower tiers. Not all parties have access to the same information because many companies that trade in OTC markets don’t file any annual or periodic reports with the SEC, making it extremely difficult for the average investor to get any real information regarding these companies.
OTC Markets’ OTC Pink tier, for instance, has no requirements for disclosure whatsoever, and stocks aren’t required to be registered with the SEC. The existence of a market like OTC Pink gives any company, no matter how small or challenged, a chance to seek out capital and get its business up and running, not to mention gives any investor a chance to buy equity and potentially capitalize on future success. That’s something that can sometimes give good companies a chance to thrive in the long run, or savvy investors a chance for massive returns, so maintaining a wide-open marketplace like OTC Pink clearly provides a valuable service to the markets.
However, by lowering the bar for entry into the market so low, it can also attract companies that are on the verge of bankruptcy or even engaging in outright fraud. And without regular reporting, it can be exceedingly difficult to know which companies these are. Any investor buying shares on OTC Pink is immediately accepting a range of risks that simply don’t exist in more-established markets. If adequate research is done, those risks can be reduced, but it places the onus on the investor in a way one doesn’t see with the more restrictive marketplaces.
Many penny stocks trade on OTC Pink. Accepting big risks for the chance to invest in the early stages of a company’s lifestyle pretty much what trading penny stocks is all about, but the risks of falling victim to unscrupulous executives or financiers is something that one rarely has to seriously consider when sticking to the NYSE, Nasdaq, or even OTC Bulletin Board.
Opportunities Abound for Market Manipulation
Penny stocks can also become easy targets for stock promoters and manipulators. The fact that penny stocks don’t report financials with the same regularity and transparency as their larger cousins, and that they often lack liquidity, makes it much easier for unscrupulous traders to move the market for the stock. A slanted research report trying to smear Bank of America’s stock is easily spotted and countered by other voices in the market, but a similar hatchet job on a thinly-traded penny stock can have a huge effect on that stock’s market value.
There are also a variety of price manipulation schemes that would be nearly impossible with larger companies but enter the realm of possibilities when you’re talking about penny stocks. One of the most common tactics is what’s known as a “pump and dump” that can be traced back almost as far as people have been trading stocks.
Generally, firms or individuals will purchase large amounts of the stock and then proceed to artificially inflate the price of the stock through misinformation and false positive statements about the company. Once the price of the stock is inflated enough, the pumper will proceed to sell off the shares he/she owns and walk away with a huge profit.
While it’s at least hypothetically possible to pull this off with any stock, pushing up the price of a penny stock is much easier. There have been many high profile cases of pumping and dumping penny stocks, including that of the well-known criminal/investor Jordan Belfort, the main character in Martin Scorsese’s film The Wolf of Wall Street.
Have Penny Stocks Been Successful?
So, it sounds like investing in penny stocks means putting your money into smaller, potentially shadier companies. Why do it?
For one, penny stocks usually have a comparably low cost of entry. If you can buy 100 shares for $10, it’s easier to play the markets. Relatively substantial positions in a company can be had on the cheap, making it appealing to investors not interested in making a major investment but still looking to get in the game. What’s more, one can also make a lot of different plays, pushing small sums into a variety of companies.
The most important reason, though, is that some penny stocks have been wildly successful. When a company is as small as these penny stocks are, the room for growth is tremendous. For your typical blue chip on the S&P 500, a good year is maybe 10% gains. But for a penny stock, it’s not uncommon to see companies that will lap that figure six or seven times over, or even more.
One example is pharmaceutical company Mylan Inc. (MYL) . Mylan Inc. was first founded in 1961 in White Sulphur Springs, W. Va. They first became a publicly traded company on the OTC Markets in 1973. The stock opened at $1.50 per share in 1973 and reached a low of $0.75 per share in 1976. But by 1986, Mylan was on the rise and had moved to the NYSE. Mylan consistently traded under five dollars per share for its first five years on the NYSE. Growth started to pick up in the 2000’s and now the company trades at $50 per share and has a market cap of almost $19 billion.
If you had purchased $10,000 in Mylan at $0.75 per share in 1976, it would be worth close to $700,000 today. Even when adjusting for inflation, the gain is over 1,700%.
For the most part though, penny stocks are not overwhelmingly successful, hence the concept of high risk and high reward. For example, Idaho Bancorp ($IDBCQ), a holding company for the Idaho Banking Company, was trading at around $2.50 in 2009. Now the stock is trading at around $0.05, representing a 98% loss for any poor soul holding shares that whole time.
Many Eggs in Many Baskets
When it comes to penny stocks, there are no safe bets. But even though penny stocks are volatile assets, they present an interesting hedging strategy. For example, if you invest $1,000 in ten different penny stocks, nine of out the ten go bankrupt, but your portfolio can gain value as long as that tenth stock is a big winner like Mylan Inc.
For those traders and investors with a healthy appetite for risk and the time to put into really researching his/her options, that makes penny stocks an appealing option. Even getting just two or three picks out of ten right can mean pretty solid returns, and doing better can result in a portfolio that explodes in value.
A Bet on the Economy
Penny stocks are usually popular when the market is booming, a time when people are usually happy to take on more risk. During the tech bubble of the late 90’s, penny stocks soared in popularity and many believed the right penny stock could make someone a millionaire overnight. Then, when the tech bubble burst, the market crashed and penny stocks lost their popularity. In a sense, investing in penny stocks is a bet on the economy.
Penny stocks usually only do well when the market is booming. Investing a large sum of money in a variety of penny stocks is a bet that the market is going to thrive. If the market slows down or crashes (as was in the case in 2000), then penny stocks tend to take a nosedive, often times right into bankruptcy.
Making a Comeback
In the Great Recession, penny stocks suffered a predictably brutal fate, but almost six years removed from financial catastrophe of September 2008, we are now starting to see a rise in the popularity of penny stocks. Right now, investors are buying up shares of companies not listed in major exchanges at the fastest pace ever. OTC Markets Group has seen the average trading volume rise 40% this year compared to last year.
Generally speaking, when investors gravitate towards OTC markets, there is a renewed interest in risk. It signals growing investor confidence in the economy. Accordingly then, bolder investors make bolder decisions about where to invest their money.
It’s always important to remember though, as an investor, that OTC markets are far less regulated than major stock exchanges. Fraud is not as easily detected which presents substantially more risk to the investor. The penny stock you think is a solid winner may not be all that it appears.
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