The main reason that you don’t hear about people investing in penny stocks is that most novice or new penny stock investors lose money. They don’t want to talk about the $1,000 they threw away, and so they sweep their mistakes under the rug.
You will hear, or course, from the office jerk who is making money on a penny stock. And you probably heard about it yesterday, and will again tomorrow.
Despite the taboo nature of the subject among investors who have been burned, a quiet and significant army of penny stock traders is busy building personal wealth through these low-cost shares.
Next time you’re at a wedding reception, family reunion, or office party, bring up the topic of investing. See if you can find people who will admit to trading penny stocks. You will certainly find a few, and probably more than you would expect. My guess is that many of them lost money.
Room to grow
In addition to the growing interest in penny stocks, many of the underlying companies are also expanding, making the economic footprint of smaller corporations more significant.
A small company can grow in a variety of ways, including through
❯❯ Market share: A growing market share is a great indicator for the success of the underlying company. If that market share is being taken from direct competitors, a growing market can be an even better sign. Keep in mind, though, that a growing market share may take many months to show up in the earnings or share price of the penny stock company.
❯❯ Revenues/sales: Known as the top line number because it’s displayed on the first line of the income statement, the revenues (sometimes called sales) shows you exactly how much money a penny stock is bringing in by selling their product or service.
❯❯ Employees: Growth in employees sometimes demonstrates an increased focus on capturing more sales. Other times it shows that the company is requiring a greater workforce to meet the increased demands of its customers. In either case, as a company grows, so will its headcount.
❯❯ Mergers, acquisitions, and amalgamations: When two or three companies merge into one, or they are bought out by a bigger corporation, a 10¢-penny stock can quickly increase in value. Of course, the original business model of the smaller company will be significantly changed. These events are also quite costly at first, and thus place an additional expense on the corporation. As well, such events are not always great for investors because, although the new company may be bigger and worth more, the original shareholders may not be given fair value in the new corporation.
❯❯ Recurring billing: You can easily analyze the growth in penny stocks that derive revenues from recurring billing and subscription fees. Track the number of recurring billing customers to have a clear representation of the underlying growth and upcoming revenues.
❯❯ Average order size: When the average order size per customer doubles, total revenues should theoretically double as well.
You know that penny stock investing is risky. You’ve probably heard some pretty scary stories about scam artists and investment dollars disappearing overnight. Although investing well in fundamentally solid penny stocks can be very lucrative, the unfortunate fact is that many of the negative things you’ve heard about penny stocks are all too real.
Whether you’ve heard about an elderly widow being swindled out of her life’s savings by some con artist over the phone, or some 14-year-old child running a pump-and-dump scheme out of his mother’s basement, such awful stories have some basis in reality. By recognizing this fact, you will be able to sidestep potential pitfalls much more easily.
Penny stocks represent low-quality companies
Stocks rise in value when the underlying company does well and fall in value when the business does poorly. Therefore, more successful companies typically have higher share prices, while the majority of troubled businesses become penny stocks, if they aren’t trading at those levels already.
When a penny stock company does really well, its shares tend to move higher and eventually may rise above five dollars per share. And as soon as the price rises above five dollars, the stock is no longer considered a penny stock. As a consequence, the universe of penny stocks is made up of only the companies that have not yet done well enough to rise above penny stock territory. The result is that penny stocks are lower-quality companies, and lower-quality companies tend to be penny stocks.
If you want to play in the universe of penny stocks, you will need to have at least two characteristics:
• A good filter. The better you are at screening out the lower-caliber companies, and the more effective you are at finding the up-and-coming corporations, the more impressive your results will be.
• A strong stomach. You need to be able to handle the higher volatility and potential downside if you’re going to be involved with penny stocks.
You may not have a good filter at first. You may not have a strong stomach when you start out. However, you can gain these attributes over time in direct proportion to how involved you become with trading speculative, low-priced shares.
Penny stocks are subject to price manipulation scams
Because penny stocks are more thinly traded, and prices are much lower per share, they tend to be easy targets for price manipulation. They also tend to represent lower-quality companies and trade on markets with fewer manipulation controls and regulatory oversight.
Pump-and-dump artists may drive up the shares of near bankrupt companies through their free online newsletter, only to take their profits and walk away. When they stop promoting the shares, the stock crashes back down. Dishonest promoters may paint a very weak company in a positive light, a process called putting lipstick on a pig.
In any case, the prices of shares may rise well above what they are realistically worth. This price manipulation puts investors (who haven’t done proper due diligence) at significant risk, because shares always return to their appropriate valuations. The good news is that you can avoid these types of price manipulation pitfalls pretty easily by following the guidance I offer in Chapter 4.
Trading penny stocks is a game of chance
For some investors, penny stock investing can be like a playing a slot machine at the casino or buying a lottery ticket. Such investors have resigned themselves to the fact that they are taking a chance on a big gain, but will probably lose. The house odds are stacked against them.
But traders who perform proper due diligence never consider penny stock investing like gambling. They only invest their money when the “odds” are stacked in their favor. They have a clear understanding of which penny stocks to avoid, and which are likely to increase in price, and why, and when.
Whether or not penny stock trading is like playing at the casino depends on how you approach your trades.
The number-one reason people get involved in penny stocks is to get rich quick. They have a few hundred dollars, which they need to turn into several million before the weekend so they can buy a yacht and pay their telephone bill.
The likelihood of getting rich quickly from penny stocks is slim (although it is possible). My experience has shown me that those who want to get rich quickly never do. Those who focus on investing well, and perform their own due diligence, tend to do dramatically better.