Penny Stock Nation

Is cheap how you feel? Looking over this week's actively traded stocks, one would think Wall Street had died and gone to penny stock heaven. Lucent (NYSE: LU  ) kicked off the week by topping the New York Stock Exchange on Monday, closing at $3.31 on volume of more than 40 million shares. On the Nasdaq, it was Sirius Satellite Radio (Nasdaq: SIRI  ) on top, shedding $0.17 a stub to close at $2.21.

A fluke? Sadly, it wasn't. Tuesday brought more of the same. Lucent once again topped the most actives while Sirius came in second for the day's Nasdaq trading, wedged between tech bellwethers Microsoft (Nasdaq: MSFT  ) and Intel (Nasdaq: INTC  ) . On Wednesday, it was DSL.net (Nasdaq: DSLN  ) , fetching all of 77 pennies a share, that took Sirius' spot for the Nasdaq silver while no one was going to deny Lucent another night's sleep at the top.

Batten down the hatches and lock up your teenage-priced stocks! Penny stocks, which are broadly defined as stocks trading for less than $5 a share, are taking over. Or are they?

Most alarming
This would probably be the right time to rip the Most Actives listings themselves. Who came up with this deceptive heap of number-crunching garbage? Most newspapers will print what they claim are the 10 most active stocks on each of the major stock exchanges. It's a sham. I remain a ticked-off skeptic because I think it's a misrepresentation to not use weighted market caps to illustrate what investors are really buying into.

Why should trading volume of 20 million shares -- at $2 a pop -- be more significant than a $20 stock moving 2 million shares on any given day? It's the same amount of money exchanging hands, right?

It's like arguing that 99 Cents Only (NYSE: NDN  ) should be more prolific than Ford (NYSE: F  ) just because the thrifty retail chain moves more $0.99 trinkets than Ford does on its $30,000 vehicles. When trading volume on DSL.net went through nearly 60 million shares on Wednesday, it was actually the cash equivalent of only 555 shares of Berkshire Hathaway (NYSE: BRK.A  ) . Bah! If a pineapple gets into a fight with a hundred seedless grapes, I'm sorry, my money is on the pineapple.

The end result of the reporting oversight is that penny stocks wind up at a boxed soiree of media attention that they never should have been invited to. Most Actives might as well be Most Photogenic or Most Alphabetical. It's worse than useless. It's misused.

Penny Martial
Chasing coppers, be it for profit or sport, is a dangerous pursuit. The Motley Fool's Penny Pal newsletter back in April was a joke with an educational kicker for a punch line. We simply played off our successful premium research products such as Motley Fool Stock Advisor and Hidden Gems to roll into a lesson of penny-priced problems. In three nutshells:

  • Liquidity. Yes, we've all had that great dining experience at an obscure eatery off the beaten path, but how hard was it to find a cab when you were done? How high was the fare? Because most penny stocks trade in small cash amounts on any given day, the only thing harder than buying in is often selling out. But even if you're not a big spender, you will still pay the price in wider spreads. Yes, a stock going for a $0.40 bid and $0.45 ask may seem like only a nickel, but it's actually a 13% hole you're digging yourself into. You would probably scoff at an established company that's taking buy orders at $45 while simultaneously cashing investors out at $40, so why lower your standards?

  • Research. "Doo-doo due diligence" isn't a song by The Police. It's what you'll often find when you try to peel back the pink sheets. Information is typically hard to come by when it comes to penny stocks and sometimes companies are obscure because they want to be obscure. It's hard to make informed decisions in the dark. It's even harder to justify making an informed decision on a company that is manning the light switch and refuses to illuminate.

  • Fraud. Because of the first two factors, this is like Candyland for sugar thieves. It's easy to exploit situations in which volatility and misinformation can get the ball rolling with the slightest nudge or whisper. If your first exposure to a penny stock was either in an online chat room or message board, consider the source. Easy manipulation makes this a "pump and dump" playground and if you're not doing the illegal pumping, that usually means you're being dumped on.

Scented cents
Generalizations fail because there is always that lucky individual who managed to buy and sell at the right time. You also have some respectable companies that have just happened to fall on hard times. We have broadened the penny stock definition to exclude companies fetching market caps greater than $100 million. Liquidity, access to information, and fraud aren't likely concerns when you're considering companies such as Lucent or JDS Uniphase (Nasdaq: JDSU  ) .

Quite a few of us here have actually penned favorable analysis on stocks trading on the cheap end of the fiver. Over the past few days, I have written upbeat pieces on Gateway (NYSE: GTW  ) and Register.com (Nasdaq: RCOM  ) , but that optimism comes with a mattress as both companies have more than half of their market caps backed by abundant cash on their balance sheets. If you can make a sound valuation argument for a penny stock based on audited financials rather than simply assumptions and hand-me-down stories, I'm with you on these rare birds.

So where do we go from here? Do we take a battering ram to your local paper until it recognizes that the list of Most Actives is inaccurate and needs to be weighted accordingly? Do we draw the line of quality potential investments with erasable ink because each investor will have unique gray areas to deal with? Asking questions is always a great start. Demanding answers? That makes cents, too.

Rick Aristotle Munarriz believes that while a penny saved may be a penny earned, a penny squandered is a penny burned. He mentioned a few companies in this article and does not currently own any. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.


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