The potential for outrageous returns has often made even the most serious-minded value-investor walk on the wild side and peruse the world of penny stocks for bargains. Every stock picker alive dreams of finding the next Microsoft or Apple when they are still mired in early development, but primed to explode onto the world’s investment stage with a product that everyone must have and have now. In this series of articles, we plan to touch on the key issues that confront the penny stock investor, from selection criteria to fraudulent practices to be avoided, and from what they are and how they are traded to the reasons why you might want to buy some or try something else. Education is the objective. No investor has ever been successful without the benefit of good preparation and a knowledge foundation to support his decision making process.
To begin with, what are “penny stocks”? Unfortunately, there is no clear definition for a penny stock, or micro-cap or junior. Terms abound, but it appears the definition is in the eye of the beholder. The SEC is blunt in their assessment. It is a stock that trades for less than $5.00 and either trades in the “pink sheets” or over the NASDAQ. However, there are many substantial companies that trade at this level, so many investors add additional clarifications, such as limited operating history or less than $4 million in net tangible assets. The OTC is abundant with companies of this type, and many attribute the entire OTC market to the penny stock world.
Generally, much as with currency trading, penny stocks do not trade on an exchange, but are traded over-the-counter in a “bid/ask” environment. When certain stocks do not meet NASDAQ listing standards, they are relegated to the NNM, or NASDAQ National Market, its OTC trading market subset. Penny stocks may exist in both areas, but their primary location is usually the National Quotation Bureau service, the third major component of the OTC market, more commonly known as the “pink sheets”.
Since listing standards are lax, many pension funds, mutual funds and other investment institutions have policies that prevent investing in shares valued at less than $5.00. Companies are not required to file financial statements in many instances, but a new issuance of stock may trigger SEC required disclosures from time to time. These restrictions and the shear number of companies dilute the demand for these shares. Liquidity issues are the result. Low demand makes it difficult to sell large blocks of stock in an efficient manner, particularly if bad news in the press has prompted the desire to liquidate.
The pricing of these stocks should also be understood. Bid/ask spreads tend to be wider due to the risk and low liquidity involved with these companies. Spreads for micro-caps may commonly range from 25% to 33%, but 50% to 100% spreads are not uncommon, and some are greater than 100%. Brokers, who are maintaining inventories and supporting the market for these shares, may also add a mark-up to the spread as compensation for their services.
Despite all of these issues, daily turnover in these thinly traded stock offerings range in the hundreds of millions of shares for sub-penny stocks. The allure is real. As with early prospectors looking for the odd golden nugget as they panned on the river’s edge, many modern day prospectors search and scan the “pink sheets” daily looking for the Gold Rush to come. Wall Street investment letters and advisory services abound to support the search, but beware of scam artists, the subject of our next episode.