Penny for Your Stocks?

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By Ann Coleman (TMF AnnC)
July 3, 2001

 Q. I always hear you guys talk about staying away from penny stocks. But the fact is, Cisco and Microsoft both started as penny stocks, and those who bought in for as little as $100 are all millionaires now. So why not buy a few penny stocks when the rewards can be so great for such a small investment? -- A.B.

A. Fallacy alert! Fallacy Alert! Goodness gracious, so many fallacies, so little time. Where to begin?

First, Cisco (Nasdaq: CSCO) and Microsoft (Nasdaq: MSFT) were never penny stocks. What may be confusing you is their "split-adjusted" price. When a stock splits, historical quote services and charts split the past prices as well so that it doesn't look like the stock just dropped 50%. Split adjustments are a convenient way to illustrate the relationship between current price and historical performance, but they don't give you a true historical price. If a stock has split a number of times, the initial price can get down to pennies when split adjusted. But that doesn't mean that it ever actually sold for pennies.

For example, Microsoft went public on March 13, 1986 and closed at $28, but the split-adjusted price you will see on a chart or in historic quotes is $0.19. That's because it has split so often that a single share purchased on March 13, 1986 would have turned into 144 shares by today. Cisco has split even more. An original share of Cisco has turned into 288 shares. The closing price on the day of Cisco's IPO on February 16, 1990 was $22.25, but the split-adjusted price was $0.08. Neither Microsoft nor Cisco ever sold for much less than their IPO prices.

Second fallacy: These companies have done well, but not that well. If you had invested $100 in Microsoft at its lowest price, you could have bought four shares. If you had held them until Microsoft hit its all-time high last year of $117.50, your investment would have been worth a grand total of $67,680 (4 shares x 144 = 576 shares at $117.50). That's a very nice return on your money, but hardly a million bucks. To have made a million on Microsoft, you would have had to invest around $1,500 at its lowest point. For Cisco, you would have had to invest about $1,000. And you would have had to hold them for many years. People who sold Cisco in 1991 never became millionaires.

Now we come to the real problem with penny stocks. Even if Microsoft and Cisco had been penny stocks, how does that make investing in penny stocks a good idea? What criteria would you use to pick out the one or two possibly outstanding companies from the approximately 20,000 penny stocks that float around the fringes of the investing world? There may be some potentially great companies that are penny stocks right now, but most are either very small, very ordinary, or very near bankruptcy.

How are you planning to tell the difference? You can't use their financial disclosure filings. Most penny stocks aren't subject to the disclosure rules that apply to larger companies. They aren't followed by analysts or the financial press. What's your source of information? Hot tips from newsletters? Rumors via the water cooler? Chat rooms?

Just like the lottery is a tax on ignorance, penny stocks are the three-card monty of investing. The penny-stock world preys on the gullible and the greedy. That's where your final fallacy comes in. In the rush to hit the jackpot, how many penny stocks would you have to buy? What makes you think you're going to pick the "right one"? To have any realistic hope of cashing in on one of the rare great deals in penny-stock land, you'd have to buy hundreds (if not thousands) of them and hold them for decades. You might as well look for "the next Microsoft" among well-established companies. Honestly, it's much easier to get rich that way.

Here's how you can make money with penny stocks: Find a chat room (or start an email newsletter) and start talking up a penny stock. Wait. I missed a step. Buy a bunch of shares first. Then tell everyone that your stock is about to get FDA approval on a cure for flatulence, or has just invented a laser-powered space ship, or is about to be purchased by Cisco. Whatever. Post often using multiple screen names. Then, when the price jumps because of your self-induced demand, sell your shares and exit laughing. Make sure you spend the money quickly, because the Securities and Exchange Commission will be knocking on your door. Then, befriend Big Hairy Clyde, your new cell mate.

What now? If that last paragraph sounds like a cool idea, first read this, then spend some time contemplating your personal sense of ethics, or lack thereof.

Ann Coleman may have invested in Penney's stock (NYSE: JCP). Individual stocks that she owns now are listed in her personal profile. The Motley Fool is investors writing for investors.

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