The Risks and Rewards of Penny Stocks

Penny stocks come with high risks and the potential for above-average returns, and investing in them requires care and caution.

Because of their inherent risks, few full-service brokerages even offer penny stocks to their clients. Many are shares in companies that are headed for bankruptcy, small or new companies with little or no following, or businesses deep in debt.

There are two ways to make money with penny stocks, and both are high-risk strategies.

First, consider what penny stocks are.

The Lowdown on Penny Stocks

Penny stocks are often defined as shares that trade for less than $1. Others define them as stocks trading for less than $5. The Securities and Exchange Commission (SEC), however, defines penny stocks (or microcap stocks) as ones with a market capitalization with less than $250 million.

Generally, penny stocks trade on the so-called Pink Sheets or the OTC Bulletin Board (OTCBB). Both exchanges should be approached with extreme caution. That's especially true for the Pink Sheets since the companies traded on it aren’t required to file with the SEC, unlike OTCBB stocks.

And don’t get your hopes up even for trading on the OTCBB. It’s difficult to find enough solid information to form a logical conclusion on whether or not the company is likely to survive, let alone thrive. Keep in mind that there are no minimum standards for a company to remain on the Pink Sheets or the OTCBB.

Penny stock scammers get rich luring inexperienced investors into investing in worthless companies and taking their money. There is a long list of of common penny stock scams that you should avoid.

Pump-and-Dump Schemes

This fraud happens all the time. Promoters drum up interest in a little-known or unknown company. Inexperienced investors buy the shares, lifting the price. Once it reaches a certain inflated level, the bad guys sell, or dump, the stock at a huge profit. Investors are left high and dry.

These pump-and-dump schemes are often distributed through free penny stock newsletters. The publisher or the writer or both are paid to promote these dogs.

If you get a penny stock newsletter, read the fine print on its website. It may disclose a financial relationship with stock promoters.

Short-and-Distort Scams

This is the opposite of the pump-and-dump. In this case, the scammers use short-selling to make a profit.

An investor who sells short is betting on a stock's price falling. Using the shorting strategy, the investor borrows shares from a broker and immediately sells them in the open market. If it price falls, the short seller scoops up shares at the lower price. The borrowed shares are then returned to the lender and the short-seller pockets the difference in profit.

Penny stock scammers short-sell a stock and then make sure its price falls by spreading false and damaging rumors about the company.

Investors hold a losing stock, while the short-sellers make money.

Reverse Merger Deceptions

Sometimes a private company merges itself with a public company so that it can become publicly traded without the hassle and expense of going through traditional listing methods. This makes it easy for the private company to falsify its earnings and inflate its stock price.

While some reverse mergers are legit, you can catch a reverse merger by reviewing the business’ history and detecting spotty activity in its merger.

Mining Scams

Gold, diamonds, and oil have always had an allure, and mining scams can be traced back through the history of mankind.

One of the most famous mining scams was Bre-X, in the mid-1990s. Founder David Walsh falsely claimed his company had discovered a massive gold mine in Burma. Speculation soared until the company’s valuation, all in penny stocks, reached $4.4 billion by 1997.

When the company collapsed, most investors lost everything.

The Guru Scam

Anyone with an advertising budget can be a guru. Sadly, they often gain a devout following.

This type of false advertising promises to reveal a special secret that the financial guru used to acquire a lakefront mansion and a fancy car. The expert promises to share penny stock trading secrets with you for a one-time low sum.

Trash that email or envelope. There is no one-size-fits-all path to riches in the stock market.

Also avoid pitches from anyone claiming to be the new Thomas Edison and offering you the opportunity to invest in the biggest thing since the lightbulb.

The No Net Sales Fraud

The scammers offer shares of a stock with the stipulation that they cannot be resold for a certain period of time. The investors are told that there is a huge demand for this stock.

By the time the SEC gets around to closing these scams down, the investors are left with nothing.

Offshore Rackets

Companies that operate outside the U.S. do not need to register their shares in the U.S. when they are selling to U.S. investors. Penny stock scammers love this.

They buy cheap and unregistered foreign company shares and sell the stock to investors at an inflated price. This influx of unregistered shares causes the company’s stock price to drop. The thieves make money while U.S. investors get little or nothing.

How to Avoid Scams

The penny stock world is rife with market manipulation, fraud, and chicanery.

Investors should know that such abusive practices aren't the exclusive domain of penny stocks and micro-caps, as the notorious cases of Enron and WorldCom prove.

That said, how can you avoid being scammed by dishonest penny stock promoters who are out to make a fast buck? Below are some suggestions.

Promotion vs. Research

Promoters hire newsletter writers to write flattering reports about their stocks. They make a convincing case for investing in dud penny stocks, using hyperbole, outlandish projections, and, in some cases, deliberate distortion.

These promotional pieces look very similar to legitimate research reports. The penny stock investor has to learn to distinguish between stock promotion and equity research.

One way is to read the disclosures section at the end of the report to see whether the writer is being directly compensated by the company they're recommending, often in a combination of cash and stock.

If that's the case, this is an advertisement, not a research report.

Grade the Quality of Management

A company's success depends on the quality of its management, and penny stock companies are no different.

You're unlikely to find a Steve Jobs running a penny stock company, but you still can delve into management's track record. Find out whether the company's executives and directors have had any notable successes or failures or, in fact, any relevant experience at all.

Evaluate the Financials 

Penny stock companies generally don't furnish in-depth financial information, but it won't hurt to check the financial statements it does release.

Scrutinize the balance sheet to see if the company has any substantial debt or liabilities outstanding as well as its amount of net cash on hand.

If the income statement shows a huge growth in revenues of late, that's a promising sign.

Know the Quality of Disclosure

The more disclosure the company provides, the better. It indicates a greater level of corporate transparency.

For instance, the OTC Markets Group divides its securities into a three-tier marketplace: OTCQX (the top tier), OTCQB (middle tier) and OTC Pink (bottom tier). These categories are based on the integrity of a company's operations, its level of disclosure, and its investor engagement.

Since OTC Pink company reporting can be spotty, OTC Markets Group further segments that group, based on the quality and quantity of information provided, into Current Information, Limited Information, and No Information.

Warning Signs

Obviously, investing in a company with limited or no information is best avoided.

In addition, stocks for which OTC Markets Group advises investors to exercise additional care and thorough due diligence typically flash a skull-and-crossbones Caveat Emptor sign.

Penny stocks can earn this symbol for a number of reasons: The company or its insiders may be under investigation for fraudulent or criminal activity, or the company may be involved in such dubious promotional activities as spam emails.

Is the Business Plan Achievable?

Investors should evaluate whether the company's business plan is achievable and if it actually has the asset base it professes to have.

Recall the infamous case of Bre-X, mentioned above. It was a Canadian exploration company that claimed to have found one of the world's biggest gold mines in Busang, Indonesia.

The story turned out to be a colossal fraud. Before it was found out, Bre-X shares climbed from 12 cents to $280.

Its collapse in 1997 wiped out $3 billion Canadian in market value.

How to Buy Penny Stocks

Once you've learned to dodge the scammers, there are five steps to follow when purchasing a penny stock. 

It's important to evaluate whether the stock has upside potential. You're investing because you'd like to get a return, right? So you need to ask yourself whether the penny stock you're considering truly has upside potential, or if it seems more to be a flavor-of-the-day stock, such as a company that's trying to ride the coattails of the latest investment fad.

Four Rules to Follow

You should devise a realistic risk-reward assessment for the stock even if you're only investing a small amount of money.

1. Limit your holdings and diversify. You might be excited about the prospects for your favorite penny stock, but you still need to protect yourself. Cap your losses by limiting your holdings in the stock to no more than 1% or 2% of your overall portfolio. It also makes sense to diversify your penny stock portfolio, which shouldn't exceed 5% to 10% of your overall portfolio, depending on your risk appetite.
2. Check liquidity and trading volumes. Even if you've made a successful investment in a penny stock, you'll want to sell your shares eventually. You should have adequate liquidity and trading volumes in the stock so that you can trade it efficiently. Otherwise, you may wind up with a wide bid-ask spread, making it nearly impossible to convert your paper profit into an actual one.
3. Know when to sell. It's rare for a penny stock to be a long-term buy-and-hold investment. The sector is built on short-term trades. If you notch a sizeable gain over a short period, book it now rather than waiting for bigger profits that may never materialize.
4. Search for high-quality stocks. Good prospects include ventures that are set up by experienced managers who have successfully exited a previous company, and stocks with promising outcomes in biotechnology or natural resources. There also are fallen angels. These are the once-great companies that ran into trouble but still have comeback potential. Many of today's leading technology stocks were trading in the low single digits at the end of the 2000-2002 "tech wreck," and household names like La-Z-Boy Inc. (LZB) traded below a buck in March 2009. 

Using an Online Broker

Most online brokers offer the ability to buy and sell penny stocks through their platforms. We've done an extensive review and ranking of the Best Online Brokers for Penny Stocks to help you pick the right one for you.

Buyer Beware

Penny stocks are a huge gamble. A casino might have better odds.

Despite the short-term potential for gains, stick to a sustainably profitable approach by buying shares in proven companies with strong track records.

If you want to allocate some capital to speculative plays, it may be best to look at companies trading between $3 and $5. But only pull the trigger after substantial research that leads to a conviction in your position.