Who's Afraid of a Penny Stock?

If you're looking for more than index-like returns, you'll have to successfully navigate the market's ongoing fear-to-greed continuum. Lucky for us, few corners of the market invoke more unnecessary fear and blind greed than the perceived dark alley of penny stocks.

Warning! If the idea of investing in a penny stock scares you to death, makes your stomach turn, or makes you want to run for the hills, please, please, please, stop reading this right now.

I offer this warning because it's true, the novice investor should never, ever invest in a penny stock, period. However, if you are among those whom Benjamin Graham called an "enterprising investor," who is able to discern share price from the true value of an enterprise, we can talk.

Penny stocks vs. worthless companies
The Securities and Exchange Commission broadly defines "penny stocks" as low-priced (below $5), speculative securities of very small companies. True, many of them don't file financial reports with the SEC, have limited operating histories, and hold little to no reportable assets. The average microcap stock that the SEC suspended trading in had roughly $6 million in net tangible assets -- and nearly half had less than $1.25 million.

While most of these stocks are indeed garbage, a fair number of low-priced stocks trade on traditional securities exchanges and do provide up-to-date financials. Most rookie investors have either been scared off or burned so badly by penny-stock speculation that they have summarily sworn off any and all companies with single-digit share prices.

But we know that whenever other investors make blanket assumptions based solely on emotion or without evaluating evidence contrary to their beliefs, market mispricing often follows. And because institutional investors also generally ignore low-priced stocks, it remains a stocked pond for fishing out opportunistic values.

A basic stock screen for stocks trading on major U.S. exchanges for less than $5 produces about 1,500 candidates. Digging deeper, 131 of these companies have market caps above $500 million, a majority of which (89) are bigger than $1 billion.

Recognize these names?

Company

Share Price

Market Cap

Citigroup (NYSE: C  )

$3.44

$95.4B

Sprint Nextel (NYSE: S  )

$3.34

$9.6B

Sirius XM Radio (Nasdaq: SIRI  )

$1.11

$4.4B

Data from Capital IQ, a division of Standard & Poor's.

This just goes to show that all penny stocks are not created equal.

Being a penny stock doesn't automatically mean that it's not a real operating company with a viable business model. Usually, these are companies that have fallen on hard times -- whether it's a burdensome debt load, share dilution, negative industry trend, or the loss of a major client. The trick is separating the underdogs from the dead ducks.

Pitching pennies
Even some of the best small-cap managers in the world aren't scared to invest in penny stocks, either. Bruce Berkowitz -- investing legend in the making -- stops to pick up the occasional penny. Recently, he's been actively accumulating shares in Citigroup for his Fairholme Fund (FAIRX) -- a fund with 13.4% annual returns since its inception versus a 0.9% loss for the S&P 500.

The team from Royce Funds likes the space so much, it has  dedicated Royce Low-Priced Stock Fund (RLPHX) and Royce Micro-Cap Trust  (NYSE: RMT  ) to it. A quick dig through Royce filings yields some interesting ideas:

Company

Share Price

Market Cap

Price/Book

Euroseas (Nasdaq: ESEA  )

$3.89

$120 million

0.48

dELiA*s (Nasdaq: DLIA  )

$1.70

$53 million

0.50

Thomas Weisel Partners (Nasdaq: TWPG  )

$3.96

$126 million

0.93

*Roycefunds.com and Capital IQ, a division of Standard & Poor's.

On first glance, these pennies appear to be trading cheaply. While much more in-depth research would need to be done, these types of low-priced opportunities tend to catch our eye.

Special opportunities
Again, we don't like penny stocks simply for their share prices. However, what we do enjoy is that most institutions, Wall Street analysts, and mutual funds either won't or can't dive into these depths of the market. Low-priced stocks are just one of many rich areas where a significant amount of players are simply too greedy or too fearful to profit from.

That's one of the reasons the Motley Fool Special Opportunities team was formed. Led by old school Fool Tom Jacobs, we dig through the rubble to find unique opportunities that the market has quietly left for dead. We search through low-priced stocks as well as bankruptcies, spinoffs, and even discarded large caps that the market either doesn't understand or ignores in plain sight. We use scuttlebutt research, look through cash flow statements, value companies by the sum of their parts, and run a host of proprietary screens to unearth the absolutely best investment candidates.

Membership to this service will be strictly limited, so only request a special invitation below if you're serious about opportunistic value investing, want to compound returns better than the market, and enjoy working with a community that will continually push you to be a better investor. If so, enter your email address in the box below, and I look forward to serving with you.

Motley Fool research analyst Andy Louis-Charles doesn't own shares in any company mentioned. However, his mother is quite happy that he will finally be putting his law degree to work, performing complex due diligence on the next great "Special Op" stock. Sprint Nextel is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 24, 2010, at 2:48 PM, nwaldman89 wrote:

    can someone explain to me exactly what the royce micro cap fund is?

  • Report this Comment On February 24, 2010, at 4:41 PM, southernbeachguy wrote:

    Pretty Good article! Sirus, Sprint and Citi may be considered Penny Stocks, but they are NOT Pennny stocks in the true sense of the meaning. They now have a lower PPS because of the Economy and other mitagating circumstances. They will be above $5 sometime in the near future. Sirus has made me a tremendous profit in the past year and has a great product that is about to expand worldwide. Their today revenue is generated now only from North America sales. They will double or triple when they enter Europe, Asia and South America.

  • Report this Comment On February 24, 2010, at 7:07 PM, Elconkwistador wrote:

    I guess I am an idiot. I have bought shares in the companies listed below based on claims they made that they are already pumping oil out of the ground or are acquiring medical clinics or have found gold: BNXR and BDGR = oil, BEDA = Med clinics/ diagnostics, and AMOK = gold. I have only a few hundred dollars worth of each stock . I assume that if they go down I can use them as tax write offs. The bulk of my money is invested in REITS like ANH and CIM which pay a nice dividend.

  • Report this Comment On February 24, 2010, at 7:20 PM, DiscoFinance wrote:

    If you like Sirius XM then see their “rags to riches” story on DVD. The movie is called “Stock Shock” and it goes over the history, development, and near-death experience of the stock. I did not know the inventor of sirius xm was a woman!–well she is now, at least. DVD is cheaper at www.stockshockmovie.com, but the DVD is pretty much everywhere for sale.

  • Report this Comment On February 24, 2010, at 7:31 PM, jacobske wrote:

    MF thanks for offering this type of service. I look forward to seeing what you have to offer.

    Kip Jacobs

  • Report this Comment On February 24, 2010, at 8:15 PM, SUPERMANSTOCKS wrote:

    I own C and will be buying S soon.

  • Report this Comment On February 24, 2010, at 8:15 PM, SUPERMANSTOCKS wrote:

    I own C and will be in the market for Sprint soon

  • Report this Comment On February 25, 2010, at 12:41 AM, marcepoo1 wrote:

    Southernbeachguy, When do you think Sirius XM will be entering Asia,Europe, and South American markets?

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