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IN THIS CHAPTER

Finding out why penny stocks are so popular

Understanding the big business of tiny companies

Getting a grip on the bad press surrounding low-priced shares

Determining whether penny stocks are right for you

You’ve probably heard both sides of the argument about the value of trading penny stocks. Many investors are afraid of penny stocks because of their risk, the low quality of the companies, and the potential for fraud and price manipulation. Others point out that penny stock trading is one of the few channels in which a small amount of money has the potential to turn into significant wealth so quickly.

The truth happens to fall between these extremes. Sure, any information that’s available about the stocks is less reliable, and the underlying company may be newer and more risky than bigger, more established stocks. But compared to bigger and more established stocks, that company may provide much greater returns as it grows.

You may have heard numerous horror stories about penny stocks, and get just as many warnings about them from professionals, friends, and family members. Yet, at the end of the day, you may decide to invest in these speculative shares anyway. That investment could be a big mistake, but if you get involved in fundamentally solid penny stocks by using the methods I detail throughout this book, you could also be making a very profitable move.

In this chapter, I explore the growing popularity of penny stocks. I also reveal the big business of tiny stocks and detail the numerous negative connotations surrounding low-priced shares. My aim in providing you with all this information is to help you decide if penny stocks are an appropriate investment vehicle for you.

Gauging the Popularity of Penny Stocks

As the world goes increasingly digital, researchers can more easily track people’s interests based on their online activity. And just as you may expect, data from top sources indicates that people’s interest in penny stocks is on the rise.

The term “penny stocks” is one of the most popular financial queries on the major search engines, topping such phrases as “stock pick,” “stock quote,” “New York Stock Exchange,” “NYSE,” and “stockbroker.” Such searches represent millions of people worldwide actively looking for tips or guidance about low-priced shares, and that broad-based interest is growing.

I offer some reasons for the increasing interest in penny stocks in the following sections.

A high risk/reward ratio

You’ve heard the old adage, “the higher the risk, the higher the reward.” This saying is especially apt when it comes to penny stocks. Investing in speculative shares is always very risky.

However, you can dramatically reduce your risk in penny stocks – while maintaining your higher reward potential – by abiding by the various concepts I detail in this book.

I’ve personally lost $15,000 on a penny stock (risk), but I have also turned $30,000 into $500,000 (reward). After having traded all types of investments, from real estate to options and from currencies to derivatives, I’ve never found a more lucrative or reliable method for building wealth than buying fundamentally solid penny stocks.

The risk-reward ratio increases as you move down the list of these investment vehicles:

❯❯ Hiding money under your mattress: Barring a house fire, you won’t lose your principal with this savings strategy, but you won’t gain anything, either. Of course, even cash stuffed in your pillow will lose its purchasing power due to the effect of inflation.

❯❯ Certificates of Deposit (CDs): These investment vehicles have very low risk, but you get paid very minimally because they’re so secure. An investment of $100 may be worth only $102 a year later.

❯❯ Bonds: Government or corporate bonds expose you to minimal risk but have very low payouts. If you invest in bonds issued by riskier countries or companies, you can make a little more, but also increase the possibility of losing your money.

❯❯ Real estate: Property ownership has generally been profitable over time in most areas. However, the risk-reward ratio depends greatly on the area and your timing. Florida condo ownership was very profitable for a long time – until home prices collapsed and many people lost their shirts. Real estate investments also entail significant carrying costs (property tax, insurance, condo fees), and when you sell you face numerous disposition fees (real estate agent commissions, land transfer tax).

❯❯ Blue-chip stocks: Big name companies are generally considered to be safe investments, but they can drop in value and very often do. Although blue chips generally provide better returns than CDs or bonds, they can also go down in price, and so the potential for greater returns comes hand in hand with increased risk.

❯❯ Midrange and small cap stocks: These investment vehicles are riskier than blue-chip stocks and safer than penny stocks, making them a good option for people who aren’t quite ready to trade very small, highly speculative companies associated with the tiniest of shares.

❯❯ Penny stocks: Penny stocks offer the perfect mix of risk and reward for many individuals. You can push the odds of making money strongly in your favor by using the techniques I describe in this book. Plus, penny stocks are easier to understand than complex strategies required for options trading and they have the potential for bigger returns from smaller investments, when compared to other investment types.

❯❯ Options and derivatives: These extremely risky investment vehicles are only appropriate for complex hedging strategies. If you don’t understand what I mean by “complex hedging strategies,” then you shouldn’t trade options.

I’ve made money from each of these investment vehicles and I’ve also lost money from most of them. If you seek absolute safety for each dollar you invest, then penny stocks aren’t appropriate for you. However, if you are willing to assume risk in the hopes of creating some more money from your portfolio, you’ve come to the right place.

Limited funds

Of the many reasons why an individual may be attracted to penny stocks, the most popular is that the investor has limited funds. Whether you have only a few hundred, or a couple thousand, dollars to invest, low-priced shares afford you an opportunity to turn that small amount of cash into something much more substantial.

Investors with small amounts of start-up cash also tend to be more interested in taking a shot at something, almost like they’re buying a lottery ticket, partially because they feel that they don’t have a lot to lose. This is precisely the wrong approach, especially if you have limited funds.

I always suggest that investors with limited funds, or even those with no funds at all, start off by paper trading, as I detail in Chapter 5. Only after you discover how to find penny stocks of great fundamental quality, and to trade them well, should you venture into using your limited amount of real money.

Risky misconceptions

Unfortunately, traders are prone to a number of misconceptions about penny stocks, many of which can expose them to unnecessary risk:

❯❯ They can’t fall much lower. If a stock falls to pennies from several dollars or more, some investors wrongly believe that the shares can’t go much lower. Don’t make the mistake of comparing any stock to where it was before, because the stock has no memory, and past levels have no bearing as to where it may go from here. For example, even a stock that fell 99 percent – from $5 to 5¢ – can go a lot lower, and might just be on its way to 0.

❯❯ It’s not a big investment. If you invest $500 in a stock rather than $5,000, you’re risking less money (or, to use investment lingo, your downside is limited to $500). But the size of your downside has no bearing on whether the underlying shares are a good investment. If your reasoning is that you didn’t invest a lot, you’re gambling. If you buy a stock because it has an outstanding management team, low debt load, and expanding market share, you’re investing.

❯❯ The downside is smaller than on blue-chip stocks. Just because penny stocks are closer to zero than large blue-chip stocks or more expensive shares, it doesn’t mean that they are less risky. A $455 stock can go to 0. A 4¢-penny stock can go to 0. In either case, you can lose 100 percent of your investment.

My aim in addressing these risky assumptions is to help you approach penny stocks in the most knowledgeable, and therefore most profitable, way. Every dollar put into the market is at risk, and by being fully aware of that risk, you are in a better position to make wise trading choices.

Taking Stock of the Big Business of Penny Stocks

Small businesses are the source of the majority of economic growth in the United States, and this is probably true in most nations worldwide. In addition, the small-business sector is America’s largest employer.

When small businesses need to raise capital, they often go public by listing stock on the market (I describe this process in Chapter 3). Some of these companies are tiny, or just getting started, and their value is still low, so they often trade as penny stocks. As such, penny stocks are a big part of the economy.

In addition to making significant contributions to the economy, some penny stock companies eventually grow up and become huge corporations with hundreds of employees and share prices of $10 or $50 or more. Most people don’t realize that many corporations that used to be penny stocks helped build the economy from the bottom.

You’re not alone

Buying penny stocks isn’t as unusual of a practice as you may think. You may not realize all the people around you who have invested in penny stocks.

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.

Growth is the biggest indicator of potential increases in the prices of penny stocks. If a company is enjoying higher revenues, hiring more workers, or fulfilling larger average order sizes, you can anticipate that the share price may perform very well.

Making Sense of What You’ve Heard (Much of Which Is True!)

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 …

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.

Making a Fast Million … Not!

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.

Enjoy the process, and you will come much closer to reaching your end goal. Focus on the end goal alone and you will never reach it. Like the turtle taught us when he raced the hare, slow and steady wins the race.

Penny stocks appeal to the impatient

I am an impatient investor. Perhaps that’s why I was drawn to penny stocks myself. In fact, a significant proportion of investors who follow me, as well as those who seek out low-priced shares through other channels, tend to embrace the volatility of the underlying investments. The potential to make significant moves very rapidly appeals to them, even as it exposes them to equivalent downside risks.

While impatience may be the reason why many investors seek out penny stocks, this character trait can cause investment problems. Impatient investors may sell shares at inopportune times, such as just before the stock begins reflecting stronger operational results. They may jump from investment to investment in a constant hunt for profits, which can lead to many poor trading choices (not to mention excessive brokerage commission fees).

To succeed with penny stocks, you need to choose contemplation over impatience. Give the underlying company time to let its business plan play out. As long as the penny stock is making progress, however slow, and the reasons you got involved with it in the first place still hold true, let the shares gradually reflect the improving operational results.

Keep in mind that the slower and more gradual the move up, the more sustainable the higher prices will be. Rapid and sudden price spikes typically don’t last.

The greatest gains in penny stocks come over years, not days. Shares that balloon from 5¢ to $5 only do so over the course of longer time frames, and one winner of this magnitude will trump all the 5 percent and 20 percent profits you may see from decades of trading. But only patient investors have the wherewithal to enjoy these kinds of opportunity.

Newer investors gravitate to penny stocks

Typically, newer investors are interested in penny stocks because they believe there is less downside. They find smaller and newer companies less intimidating, and they expect such investments to be more attainable and appropriate for their minimal level of trading experience.

Although such reasoning isn’t without merit, it can be dangerous. There is just as much downside risk in a 1¢ stock as in a $99 stock (100 percent loss potential in each case). Also, finding high-quality penny stocks is much more difficult than uncovering good investments among larger shares, mainly because low-priced stocks have fewer companies of high caliber and a greater percentage of lackluster options.

Despite the aforementioned pitfalls, newer investors may find many benefits to starting off with low-priced shares:

❯❯ Broader diversity of investments. Newer investors will learn much more from trading numerous types of investments, rather than just buying one or two. With penny stocks, you can spread a small investment among several stocks.

❯❯ Greater volatility. Larger and ostensibly more boring investments will not teach their shareholders much. Penny stocks will display greater volatility and, as such, be more educational for the newer investor.

❯❯ Price moves happen much more quickly. Whether your investment is going to go up or down, it will happen over a much shorter time period than with larger stocks. Newer investors tend to be attracted to these faster price moves.

❯❯ Steeper learning curve. Newer investors have the most to learn. The combination of greater volatility in penny stocks, rapid price moves, bigger magnitudes of those moves, and the potential to own several different stocks at once, enables inexperienced traders to get up to speed very quickly.

For newer or less-experienced investors to quickly learn about trading, or to develop their own styles to afford them the greatest opportunity to profit, penny stocks may be the perfect outlet.

When I talk about high-quality penny stocks, I’m referring to specific criteria that add to the strength of the investment. Among other factors, these include a strong and respected management team, low debt loads, plenty of positive cash flow, positive earnings, growing market share, and low customer attrition rates. Other criteria include having a solid position within an industry with high barriers to entry, strong alliances with top customers, improving financial ratios, and very effective branding and marketing. You can find out more about all these ways to analyze penny stocks when you flip to chapters 8, 9, and 10.

Penny stocks appeal to smaller portfolios

Individuals with less money to invest may only be able to afford a few shares in a larger company. They also may not be too impressed by 5 or 10 percent gains, especially if that adds up to only $50 over the course of an entire year.

Given their situation, many investors with minimal portfolio values opt to not invest at all. Others gravitate to penny stocks.

Investors who believe in the power of penny stocks, yet who do not have a significant portfolio, understand that low-priced speculative shares may be the best way to increase their financial standing. Of course, not all traders who buy and sell penny stocks have a small portfolio, but a significant portion of traders with small portfolios do trade penny stocks.

Being Honest with Yourself: Are Penny Stocks Right For You?

Penny stocks appeal to millions of investors and potential investors. Low-priced shares have probably caught your attention as well, as evidenced by the fact that you are reading this book.

Take a moment to consider if trading penny stocks is actually appropriate for you.

Penny stock investing may be most appropriate for individuals who

❯❯ Are willing to do the work required. Investing in speculative shares requires effort on your part. Proper analysis, performing due diligence, and monitoring the shares you purchase, all require work. Investors who put in the time garner the greatest rewards.

❯❯ Possess a high tolerance for risk. You will enjoy penny stock investing more if you can tolerate risk and volatility well. If you are going to lose sleep over 20 percent price swings, safer investments may be more appropriate for you.

❯❯ Intend to invest “play” or risk money. It would be a mistake to invest in speculative stocks with money intended for your child’s education or to buy groceries. Penny stocks are best traded with funds you have set aside to have some fun. Never trade with cash you’ll need for the important things in life.

❯❯ Are skeptical of what they read. The penny stock industry is filled with hidden motivations and misleading reviews of the companies. Don’t believe most of what you read, and always perform your own due diligence.

❯❯ Have realistic expectations. You might make some good money trading penny stocks. However, if you’re expecting to become a millionaire from a $300 investment, you will be disappointed.

❯❯ Have time available for research and trading. Unlike day trading or options trading, you won’t need to be glued to multiple computer screens all day long. However, the more time you can set aside to research your shares and monitor them, the greater the level of success you will probably enjoy in penny stocks.

If you decide that penny stock investing makes sense for you, I encourage you to keep reading. In the rest of this book I go over every concept I know for investing well in low-priced shares.