Penny Stocks: There’s Danger Wherever You Look

Interest  in penny stocks has surged.  In February, the most recent month for which complete data are available, share trading volume in this area jumped to 1.9 trillion transactions, a whopping 2000 percent from a year ago.  This leap will unavoidably create still more interest.  In a social media pattern that has grown all too familiar, retail investors will find it hard to resist the temptation to jump in after reading or hearing the brags and reports of great gains.  That would be a mistake.  Penny stocks are no place for most retail investors, and for a goodly number of reasons.

Penny stocks are defined by the Securities Exchange Commission (SEC) as issues that sell for under $5.00 a share and that do not trade on major exchanges, but on what is called “the over-the-counter (OTC) market.”  Most of the more than 10,000 issues in this area actually sell for far less than $5.00 a share (many, in fact, for only fractions of one cent) and can include interest in any kind of business –– from a delivery service, to a tech startup, to a hair salon.  

Penny stocks offer four huge temptations to retail investors:

1. They come dressed in stories of people who made “fortunes” buying into what became a great firm before anyone had ever heard of it.
2. The price per share is so low that just about anyone can buy in for a large volume of shares.
3. Because most of these issues trade only infrequently (and thus are “thinly traded,” in financial jargon), even only a modest interest in such a stock can dramatically drive up its price, at least temporarily and during that time create what looks like a huge gain on the investment.  (Of course, the thin trading volume means that the price can fall just as steeply when interest wanes.)   
4. Big institutional investors, such as pension funds and hedge funds, rarely get involved  in penny stocks, giving retail investors the delusion that this area of finance protects them from what they fear are market manipulations engineered by big players elsewhere.

Despite such temptations, penny stocks are dangerous on at least two counts.  First is how they invite misinformation and fraud (of which more in a moment).  The second is rooted in the sorts of companies that issue penny shares.  All are small ventures that need financial capital to turn their idea into reality.  One might need the money to set up shop in what they believe is a great location.  Another might need funds for licensing fees or permits.  Others might need it to pay staff until the project –– they hope –– can generate enough revenue.  Those ventures that succeed will pay big returns, and they will get all the play on social media and elsewhere.  Most such ventures, however, will fail and earn their shareholders an utter, 100 percent loss on their investment.  Because a successful venture will pay a return well in excess of 100 percent, such a return can pay for a lot of losses, but given the number of ventures that fail, the odds still point to a loss for most penny stock investors.

When it  comes to misinformation and fraud, there are at least two sources of danger:

1. It is hard for investors to know what they are buying.  Because penny stocks trade “over the counter,” they avoid many of the reporting rules that force stocks listed on major exchanges to provide would-be investors with useful information, such as quarterly earnings, buyback plans, and so on.  Aside from the lack of regulation, OTC investors often cannot get information even from unofficial sources.  These ventures are almost always too small to attract the attention of media outlets, even local news.  Brokers, investment advisors, and even investment newsletters, seldom follow penny stocks in general, much less offer anything on specific issues.  Not only does this information void deprive investors of what they need to make an informed decision, it makes it difficult, if not impossible, for them to determine if the trickle of information they do have is accurate.
2. Frauds and scam artists see opportunity in this lack of verifiable information and in the price volatility that is typical of these small stocks.  The big players, who supposedly manipulate markets, may not play in the penny stock arena, but others, perhaps even more greedy and unscrupulous, often do.  Thinly traded  penny stocks are particularly susceptible to sordid “pump and dump” schemes portrayed (with altogether too much glamor in the film The Wolf of Wall Street) and explained in this post.

There is no denying that some of today’s giants started out as penny stocks and made fortunes for those who got in on what is called “the ground floor.” But most penny stocks over time have failed, and most of those around today will also fail. In fact, most will lose all the investments made in them.  As this blog has pointed out many times, there are better and more secure ways to make money –– less exciting perhaps and less the stuff of good stories, but better for your portfolio.