Successful companies aren’t born, they’re made and they have to work their way from humble beginnings and through the ranks just like everyone else. Unfortunately, some investors believe that finding the next “big thing” means scouring through penny stock in the hope of finding the next Microsoft or Wal-Mart. Unfortunately, this strategy will prove to be unsuccessful in most cases. Beware and take careful consideration when taking penny stock, pinning your hopes on penny stocks could leave you penniless.
The terms “penny stocks” and “micro cap stocks” can be used interchangeably. Technically, micro-cap stocks are classified as such based on their market capitalization, while penny stocks are looked at in terms of their price. Definitions vary, but in general, a stock with a market capitalization between $50 and $300 million is a micro cap, whereas less than $50 million is a nano-cap. According to the Securities & Exchange Commission (SEC), any stock under $5 is a penny stock. The definitions can vary; some set the cut-off point at $3, while others consider only those stocks trading at less than $1 to be a penny stock. We consider any stock that is trading on the pink sheets or over-the-counter bulletin board (OTCBB) to be a penny stock.
The main thing you have to know about penny/micro stocks is that they are much riskier than regular stocks. Four major factors make these securities riskier than blue-chip stocks.
• Lack of Information Available to the Public
In order to develop successful investment strategy, acquiring enough tangible information to make informed decisions is vital. Unfortunately for micro-cap stocks, information is much more difficult to find. Furthermore, much of the information available about micro-cap stocks is not from credible sources.
• No Minimum Standards
Stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain on the exchange. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.
• Lack of History
Many of the companies considered to be micro-cap stocks are either newly formed or approaching bankruptcy. These companies will generally have poor track records or none at all. As you can imagine, this lack of historical information makes it difficult to determine a stock’s potential.
When stocks don’t have much liquidity, two problems arise: first, there is the possibility that you won’t be able to sell the stock. It may be hard to find a buyer for a particular stock if there is a low level of liquidity,, and you may be required to lower your price until it is considered attractive to another buyer. Second, low liquidity levels provide opportunities for some traders to manipulate stock prices.This can be done in many different ways and the easiest is to buy large amounts of stock, hype it up and then sell it after other investors find it attractive.
The Penny Stock Fallacy
Two common fallacies pertaining to penny stocks are that many of today’s stocks were once penny stocks and that there is a positive association between the number of stocks a person owns and his or her returns.
Investors who have fallen into the trap of the first fallacy believe Wal-Mart, Microsoft and many other large companies were once penny stocks that have appreciated to high dollar values. Many investors make this mistake because they are looking at the “adjusted stock price,” which takes into account all stock splits. By taking a look at both Microsoft and Wal-Mart, you can see that the respective prices on their first days of trading were $21 and $16.50, even though the prices adjusted for splits was about eight cents and one cent, respectively. Rather than starting at a low market price, these companies actually started high, continually rising until they needed to be split.
The second reason that many investors may be attracted to penny stocks is the notion that there is more room for appreciation and more opportunity to own more stock. If a stock is at 10 cents and rises by five cents, you will have made a 50% return. This, together with the fact that a $1,000 investment can buy 10,000 shares, convinces investors that micro-cap stocks are a rapid, surefire way to increase profits. Unfortunately, people has the inclination to see only the upside of penny stocks, while forgetting about the downside. A ten cent stock can just as easily go down by five cents and lose half its value. Most often, these stocks do not succeed, and there is a high probability that you will lose your entire investment.
The bottom line is definitely some companies on the OTCBB and pink sheets might be good quality, and many OTCBB companies are working extremely hard to make their way up to the more reputable Nasdaq and NYSE. However, there are good stock opportunities out there that aren’t trading for pennies. Penny stocks aren’t a lost cause. They are very high-risk investments that aren’t suitable for all investors. If you can’t resist the lure of micro caps, make sure you do extensive research and understand what you are getting into.