Penny Stocks

Q:I'm considering taking a gamble on a company whose current stock price is forty cents per share, though the stock used to trade at $8 a share. I believe in this company's product, but is a small gamble ever worth it on a company whose share price is this low? -- G.O. via the Internet

A:Yikes! It sounds like you're asking about a "penny stock." Penny stocks are the stocks of small companies that generally trade at less than $5 per share and don't qualify for listing on any of the major exchanges. Statisticians note that 75% of all the companies whose stocks trade for less than $5 per share (whether on or off the major exchanges) go bankrupt over any ten-year period. These are the obscure diamond miners in Zaire, the meat-packing business that just launched an Internet service, the fingerprint-technology company that claims it will provide the foundation for all transactions in the century ahead.

Basically, our counsel on any company that you like is to wait for it to be valued by the market for at least $5 a share. The fact that a stock is selling for forty cents a share is a pretty good indication that the company is essentially bankrupt. Furthermore, the cheapness and obscurity of penny stocks makes them tremendous targets of fraud and manipulation. Penny stocks are the public market's own brand of lottery ticket -- the engine of financial dissolution among those who have not been educated about their money.

Why, when they present such little opportunity to long-term investors, do penny stocks still attract attention? Many new investors will buy them up, not having been taught that bankruptcy and micro-cap shares travel arm in arm. Inexperienced investors may be attracted by the fact that they can buy many shares for little money. To take an extreme example, $3,000 could buy only one share of Warren Buffett's Berkshire Hathaway Class B stock, but it could buy six thousand shares of, say, "Marginal Technology Systems, Inc." at fifty cents a share.

The combination of the opportunity to hold large share positions and the appearance of unlimited upside draws scads of new investors into this most highly speculative form of equities ownership. After all, if the micro-cap stock goes up just fifty cents, the stockholder would double his or her money. Never mind that the odds are very remote that this penny stock will rise and then sustain its gains.

For all of these and other reasons, The Motley Fool abhors the dreaded penny stocks. We do not report on penny stocks, except to share horror stories. Though we will not open message folders for our community members to discuss penny stocks, we do celebrate the unfortunate confessions of burnt penny-stock investors, which litter our "Dumbest Investments" message folder at The Fool.

What now? For a look at the lighter side of penny stocks, visit http://www.fool.com/School/Zeigletics/Zintro.htm and learn how to avoid penny stocks being hyped on the Internet.

Submit a question for Ask the Fool.