Penny Stock

We're going to talk about a class of stock that most of you have heard about, but may not completely understand what is meant by the term "penny stock."  In the US, investors often think of penny stocks as those issues that are not traded on one of the more prestigious stock exchanges - but that's not the complete story.

Definition of a Penny Stock

In fact, some investors use the term penny stock in a derogatory way - meaning that these particular companies are not worth holding in their portfolios.  The Securities and Exchange Commission defines a penny stock as a low-priced (under $5.00), speculative security of a very small company. To the SEC, this definition holds true regardless if the stock is traded on the NYSE or an over the counter service such as the OTCBB or Pink Sheets.

In almost all instances, the term "penny stocks" refers to the size of a company in terms of its market capitalization and is also used interchangeably with terms such as:

• Microcap Stocks
• Nano Stocks
• Small Cap Stocks

In terms of size, a penny stock company would typically have a total market capitalization that is under $500 million.  And for that reason, most investors consider penny stocks as speculative.

Penny Stocks can be Speculative

In some situation, the company issuing stock can also be a growing company with very little cash or other assets.  Since most of these stocks will trade on the Over the Counter Bulletin Board and Pink Sheets they can also be manipulated into wild swings.

Stocks traded on the NYSE or NASDAQ are much larger companies in terms of market capitalization, so it is much more difficult to for individuals and even large institutions to manipulate the price of stocks on those exchanges.  There is also no SEC filing requirement for penny stocks traded on Pink Sheets. With penny stocks, you get what you pay for.

There can also be a liquidity problem for investors in penny stocks.  Liquidity is basically the ability to convert an asset to cash quickly.  So this class of stock provides two additional challenges for the investor - liquidity and information.  Those are two more very good reasons to consider penny stocks as speculative.

Penny Stock Myths

Another problem is the misinformation concerning certain companies and their legends, or myths, of starting out as mere penny stocks.  For example, one bit of urban legend is that Microsoft started out as a penny stock.  That is simply not true.

Microsoft was Never a Penny Stock

A lot of less-than-honorable marketers out there point to charts demonstrating Microsoft started out around 9 cents a share.  In reality, it started out between $20 and $30 per share.  The 9 cent misinformation comes from historical stock charts that have been adjusted for stock splits.

For example, if a stock started at $20 per share but split 2:1 five times over its lifetime, that charts would show its early life at $0.63 or $20 divided by 32.  It does this so that you can see the price it is currently trading at with historical performance - adjusted for splits!

Quality Socks

There is no doubt that quality companies, with lots of potential, trade right now as a penny stocks.  However, most investors might be better served by looking to one of the major stock exchanges for an even better opportunity.  Even with these warnings, some investors might still be compelled to jump in on those penny stock offers.  If you go in that direction, please make sure that you research the stocks thoroughly and ignore the lore of the legends and myths. 

Penny Stock Schemes

This is a financial planning and investing e-zine.  As such we are very tapped into the financial markets and take a skeptical approach to get-rich-quick schemes.  In fact, we are inundated with offers of penny stocks "ready to take off" nearly every day.

That being said, let's set the record straight on a couple of things concerning penny stocks:

• Trading penny stocks is not the best way to learn about the workings of the stock market.  There are many other less-speculative ways to learn about trading including stock market games where the investor risks none of their money.
• While penny stocks might offer the investor lots of "excitement," that isn't necessarily a good thing.
• The potential for rewards might be greater with penny stocks, but so are the potential losses.  Fast movements in short timeframes can mean losing all of your money in just a week or two.

In fact, the SEC labels penny stocks as high-risk investments and add their concern of fraud to a list that also includes liquidity problems, and lack of financial reporting.  You'll even find websites claiming to offer "unbiased" research and tips for penny stocks.  These same sites will normally charge a nominal fee to gain access to their "unbiased" research.  Let's finish up by try to separate penny stock fact from fiction:

• Fact:  None of the major financial reporting networks even discuss penny stocks unless they are warning investors.
• Fact:  Tips on hot penny stocks that are shared through email cannot possibly be any kind of bargain.
• Fact:  Risk and reward go hand-in-hand.  The offer of a penny stock with high rewards to the investor also means there is a lot of risk involved.
  

About the Author - Penny Stock

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2007 Money-Zine.com

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