7 Reasons Not to Invest in Penny Stocks

Penny Stocks are cheap and also very volatile with lots of risks. There is a lot of price manipulations, through which some market participants try to get rich fast. So be very careful if you’re thinking of investing in Penny Stocks. The allure of penny stocks is that they are cheap and therefore expose the traders to more profits. However, we believe that you should not do so.

What are Penny Stocks?

Assume the stock price of company A is currently at $2500 and that of company B is at $2. Also, assume that you have $500 to invest in either company. Which one would you buy? Many newbies would buy company B, because it is less expensive than company A. Investing in this company would give you 250 shares while investing in company A would give you 2 shares. Therefore, a small movement in company B will make you more money compared to the other company.

This example provides a good foundation of penny stocks. A penny stock is a company whose share price is below $5. While a good number of penny stocks are listed in the major bourses like New York Stock Exchange and Nasdaq, most of them are quoted in the Over-The-Counter Bulletin Board (OTCBB). OTCBB is offered by the Financial Industry Regulatory Authority (FINRA).

As described above, the allure of penny stocks is that they are cheap and therefore expose the traders to more profits. However, while a number of investors have made a lot of money investing in penny stocks, I believe that you should not do so for a number of reasons.

Penny Stocks Are Volatile

If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes… – Warren Buffet

A common characteristics of penny stocks is how volatile they are. In a given day, these stocks see large gains or losses. Therefore, the argument for penny stocks is that you will see huge returns if the price of your investment goes up by double digits. While this is true, the reality is that the opposite is also true. You will see double digit losses if your investment goes south. This is exactly what happened to Joe Campbell, a trader who lost his money by shorting a penny stock called KaloBios in 2006. In his GoFundMe plea, he wrote that:

I was holding KBIO short overnight for what I thought was a nice $2.00 fade coming. At the close of the bell I saw the quote montage clear out and figured today there was no action after hours in the stock. So I went to my office for a long meeting. I got out of the meeting and saw a message from one of my buddy’s, he asked if I was ok since I was short KBIO.

Therefore, instead of investing in companies that can gain or lose by 100% in a given day, I recommend that you invest in stable companies that you can understand well.

Penny Stocks are Not Followed By Analysts

Another reason you should never invest in penny stocks is that these companies are not followed by Wall Street analysts. This is unlike other large companies that are followed closely by these analysts. While analyst calls are never accurate, they do help investors make decisions. For example, after earnings calls, the analysts usually get the time to ask the management questions. Therefore, since not much is known about these companies, it is very difficult for you to make an informed decision.

Penny Stock Price Manipulation

Research has shown that pump and dump schemes are rife in the penny stock industry. This is a situation where company insiders usually buy a stock in large volumes with the goal of boosting its price. After the price reaches a certain level, they exit their positions, leaving investors holding worthless stock. While pump and dump schemes are illegal, they are usually ignored by regulators, who like to focus on large-scale financial fraud.

Penny Stocks Opaque Companies

Most penny stocks are usually relatively opaque. Large public companies like Apple and Microsoft are usually more transparent to investors. This is because they have the required capital to conduct thorough filings that are required by the SEC. For example, every year, they are required to file their annual report, which provides an in-depth look into their operations.

In addition to the annual filings, the companies are required to file disclosures and other related documents. Every quarter, they hold analyst calls where they discuss their operations and performance. They also participate in various events where they receive more questions from analysts.

All this does not happen in penny stocks. First, some of these companies are really small such that they don’t have enough capital to hire professional auditors and staff their investor relations teams. Therefore, investing in a company that you don’t know much about is often risky.

No Competitive Advantage

Buy a stock the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market… Warren Buffet

As mentioned above, penny stocks tend to be small companies operating in relatively large companies. Because of their size, they tend to lack a competitive advantage, which means that large companies can easily take market share. In Warren Buffet terms, these companies lack the moat to remain competitive.

A food example of a penny stock is Eastman Kodak, which was once the biggest photography company in the world. While the company has a solid brand name, it is heavily in debt, which means that it cannot compete with well capitalized companies like Leica, Canon, and Nikon.

Another example of a penny stock that has no competitive advantage is Arcimoto, whose stock price is about $4.2. The company manufactures zero-emission vehicles for public transport. The problem with this company is that it does not have the required resources needed to scale. It also competes with other large companies like General Motors and Ford.

Penny Stocks lack of Dividends

When you invest in a company, your reward is either through share appreciation or dividends. A common thing about penny stocks is that they rarely give dividends. Also, they rarely have enough cash to invest in share buybacks. Therefore, unless a company is growing very fast or re-investing its earnings, I would not recommend investing in one that does not pay dividends.

Penny Stocks lack of Financial Reports

As an investor, you want to invest in a company you can trust. The first place you should always look at is the financial reports. These are: income statement, balance sheet, and cash flow statement. As mentioned above, large corporations are usually watched closely by regulators. To avoid the penalties, they hire the sharpest accountants and contract the biggest audit firms like Deloitte and KPMG. This ensures that their books are accurate. Penny stocks on the other hand don’t have enough capital to hire these accountants and auditors. Since they are not monitored closely by regulators, their financial reports  are usually inaccurate, which could lead to significant repercussions.

How to invest in penny stocks?

If you still want to go through and buy penny stocks, you can do so through any online broker, such as Interactive Brokers.

What You Should Do Instead

If your goal is to invest in companies with cheap stock prices, there are a number of things you can do. First, you can search and find large companies whose stock prices has fallen to below $5. For example, the stock price of SiriusXM trades at about $5. This is despite the fact that it is a $25 billion company. Examples of similar companies are Groupon (GRPN), Aslan Pharmaceuticals (ASLN), Ambev (ABEV), Lending Club (LC), and Chesapeake (CHK) among others.

Second, if your goal is to invest in relatively small companies, you can invest in the Russell Index. This is an index which is made up of small cap companies. It works like the other major indices like Nasdaq and Dow.

Finally, you can invest in companies during their IPOs. There are companies which price their IPO price at below $5. If you believe that the stock price will gain in the long-term, you can invest in it.

Crispus (BSc and MBA) is a finance professional with more than a decade experience as a financial analyst, writer, researcher, and trader. Crispus has written in-depth articles on leading platforms like CCN, Marketwatch, Investing Cube and Seeking Alpha. He also runs a forex education firm. Follow him on Twitter: @crispusnyaga and read more about us.