Small Cap Foolish 8 Pass Up Penny Stocks

We love small-cap investing, but we don't recommend going to the bulletin boards or Pink Sheets looking for ideas. With all the established, financially solid companies available for investment every day, investors would do well to scratch "penny stocks" off their list of potential purchases. Rest assured, there will still be plenty of fantastic small companies for advanced investors to choose from at any given time.

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By Dave Marino-Nachison (TMF Braden)
August 7, 2001

Motley Fool writers -- actually, I'd bet almost anyone who writes about stocks will sympathize -- are regularly hit with emails either extolling the virtues of, or asking about, so-called "bulletin-board" or "penny" stocks.

We're rarely much help. While there are perhaps exceptions to any rule, one of our "rules" here at Fool HQ is that we write off penny stocks -- a term we loosely define as shares trading for less than $5 apiece and/or companies with less than $200 million in market capitalization. The Small Cap Foolish 8 screen uses slightly different numbers: It looks for stocks with a share price of at least $7 and average daily trading volume of between $1 million and $25 million. (We'll get back to those figures further down.)

A cutoff along those (or similar) lines serves several useful purposes: First, it reduces considerably the number of stocks available for consideration. With so many solid potential investments and high-quality companies out there, investors should welcome any "screen" that simplifies the stock-picking process.

Second, and more importantly, it eliminates hundreds of companies of questionable merit. In this article, we'll discuss in further detail exactly why buying penny stocks -- most especially those not traded on one of the major exchanges (the NYSE, Nasdaq, or AMEX) -- is generally NOT what we mean when we talk about "small-cap investing." And on the occasions where a good opportunity may present itself, only advanced investors need apply.

Tossing out the pennies
Despite the seemingly giveaway derogatory nickname, penny stocks have long held a mystical attraction for many investors. This seems to confound logic.

Perhaps it's the idea that owning a large number of shares is better than owning just a few (even though it's the dollar amount invested, and the percentage change, that's really important). Or perhaps it's the preponderance of myths along the lines of "Hey, Microsoft (Nasdaq: MSFT) used to trade for a quarter per share!" That, too, is a fallacy: Those folks refer to the stock's split-adjusted price -- few truly great companies were ever penny stocks. 

But underlying those notions are two, far more fundamental ideas: first, that one might be "on to something big" or "getting in early." And second, that a low stock price means lots of room for appreciation -- or quick wealth. Unfortunately, investors who think they've found such a gem among the pennies may be undermining their own good sense. (Re-read Bill Mann's late July column "Faith in the Market" for more on this topic.)

Both attitudes run counter to the idea that investing should be an unemotional endeavor. Thankfully, investors can protect themselves from such temptations simply by scratching companies that fit the "penny" description off their lists at the outset.

Where to find them
The dot-com blowout has taken many once-high-flying companies and carried them down to penny levels. While some still trade on reputable exchanges and may yet survive, even those that have not filed for bankruptcy often suffer from familiar penny perils: questionable business models, asset-light balance sheets, and little in the way of prospects or hope.

But most penny stocks are found trading off the beaten path, either on the Over-the-Counter Bulletin Board (OTCBB) or the "Pink Sheets." (Notably, the Small Cap Foolish 8 screen excludes stocks found in either place.)

The OTCBB isn't quite the Wild West of investing it used to be. The National Association of Securities Dealers (NASD) -- which also maintains the Nasdaq -- decided a few years ago that the OTCBB needed to be a more reputable place to trade. That meant combating the pump-and-dumpers who tout thinly traded "micro-cap" stocks and often lure unsuspecting, novice, or easily tempted investors.

This was accomplished by requiring companies to be current in their SEC filings before prices for their shares could be quoted. The NASD noted, rightly -- if sadly -- two things: First, that simply having a stock quote often lends undue legitimacy to firms of questionable merit; and, second, that many of these companies don't make routine filings with the SEC (quarterly, annual, and other reports) that give investors the information required to make informed decisions. That's no longer an option.

Of course, there are still the Pink Sheets. Companies quoted there don't have to report to the SEC, meaning reliable corporate information can be difficult to find. In the case of the Pink Sheets especially, the trading volume for many stocks is so low that virtually any transaction can move the share price. (Try doing that with Microsoft (Nasdaq: MSFT) sometime!) But if just a few traders own a large number of shares, the share price can hiccup violently and you can easily be stuck with something you don't really want to own.

Neither the OTCBB nor Pink Sheets services have minimum quantitative listing requirements. (The Nasdaq, NYSE, and AMEX are exchanges dealing directly with the listed companies, while the OTCBB and Pink Sheets are quotation services subscribed to by market makers that pay to list securities.) As a result, some brokerages make investors read prepared guidelines before investing in such companies. "An investment in an OTC security," the Pink Sheets website admits, "is speculative and involves a degree of risk."

Doing it right
Of course, investing in any security is speculative to a degree, and folks who can't stomach risk at all may be better off with something like the I Bond or another savings mechanism. (Then consider index funds as a first foray into stocks.)

Further, not every company trading on the OTCBB and Pink Sheets is a penny stock or scam. Many foreign firms, for example -- including such big names as Nestle (OTCBB: NSRGY) and Nintendo (OTCBB: NTDOY) -- can be purchased over-the-counter. (Importantly, companies that do not offer American Depositary Shares, or ADS's, are not required to file electronically with the SEC and so detailed information on those companies is not as easily found.)

No screen is perfect or guaranteed to unearth a market-beating long-term investment. But sometimes screens are just as valuable for what they exclude -- in the case of, for example, the Small Cap Foolish 8 -- as for what they include.

The Small Cap Foolish 8 screen, as noted above, looks to identify promising small companies but includes several safeguards -- including the trading volume and minimum share price requirements -- in an effort to eliminate more problematic small companies. Neogen (Nasdaq: NEOG) and Women First Healthcare (Nasdaq: WFHC), for example -- two firms highlighted recently in this column space -- as of last night had market capitalizations of $92 million and $196 million, respectively.

But with the added opportunity such companies provide comes added investor responsibility. Even solid smaller companies with light market and media coverage can drift below investor radars for years, their "value" going unrecognized for long periods of time. It may also be more difficult to plot growth curves and set expectations for companies with niche markets and limited access to capital. And small-cap investors should be very comfortable with financial statements and valuation, as investors may only occasionally be presented with good opportunities to sell.

But one thing is certain: While no system is infallible, the simple step of writing off "penny stocks" is, for many reasons, a prudent strategy for most investors.

Rest assured, there will still be plenty of fantastic companies to choose from at any given time.

In Dave Marino-Nachison's opinionation, the sun is gonna surely shine. His stock holdings can be viewed online, as can The Motley Fool's disclosure policy.