Why We Love Wild Penny Stocks

Penny stocks have huge potential -- that's their blessing and their curse.

The potential rewards are enormous. Just take a look at the returns from Insmed (Nasdaq: INSM  ) , Syntroleum (Nasdaq: SYNM  ) , or Quantum (NYSE: QTM  ) , each of which has returned more than 100% since the beginning of the year. Neither traded for more than $0.61 per share when 2009 started.

Those quick jumps look like easy gains, considering that Baidu (Nasdaq: BIDU  ) and First Solar (Nasdaq: FSLR  ) would need to add more than $150 to their share prices to do the same.

Everybody loves pennies
It's the potential of quick gains in "cheap" stocks that keeps investors coming back. We typed "penny stocks" into Google, and the search engine spat out "about 1,790,000" hits. We did the same for more time-tested terms such as "blue-chip stocks" and "dividend stocks" -- the terms folks should be searching for in a bear market like this -- and got just 283,000 and 629,000 hits, respectively.

Sure, we expected a discrepancy, but the size of the gap was startling. It became even more interesting when we broke down those hits with Google Trends. According to Trends, penny stocks are particularly alluring to investors in Tampa, Miami, and Orlando -- the locales where the term is most often searched.

We hope the folks Googling "penny stocks" down there aren't retirees trying to cope with this crazy, crazy market.

This stock is set to take off! Or not.
According to the Securities and Exchange Commission, the term "penny stock" generally refers to low-priced (below $5), speculative securities of very small companies. To quote the SEC: "Investors in penny stocks should be prepared for the possibility that they may lose their whole investment." (It's worth noting that the emphasis in that last sentence is in the original.)

Pay attention to the SEC's entire definition, not just the wording on stock price. Going solely on price would wrongly categorize billion-dollar banks Citigroup (NYSE: C  ) and Fifth Third Bancorp (Nasdaq: FITB  ) as penny stocks.

Regardless, the SEC is spot-on when it says that true penny stocks are among the surest ways to lose money in the stock market.

Well, then, why do we love penny stocks?
We love penny stocks because they're fascinating. The world of pennies is inhabited by hardworking average Joes and Janes hoping to strike it rich, as well as by pumpers and dumpers, hypesters and scammers. In pennies, the logic and reason that apply in the rest of daily life are replaced by zeal and prayer.

However, we don't love them enough to actually buy them. Yes, they have big potential, but their daily gyrations are unpredictable -- the stock-price movements have next to nothing to do with the underlying company the stock represents. In fact, trading in pennies is highly illiquid, and prices are often manipulated by forces not at all related to the business.

The dangers of incredible promises
If you're buying stocks without paying attention to the businesses you're buying, then you might as well be buying a lottery ticket. Or, to use another analogy, you might as well buy up every baseball card of a benchwarmer on the Akron Aeros Class AA baseball team and hope that he someday rises up, fulfills his potential, and becomes an all-star for the big-league Cleveland Indians.

There's a better way                                                                 
Before you start saying the rest of the stock market is boring -- though you're probably not saying that any longer -- let us introduce you to some underfollowed small caps. They're nothing like penny stocks, yet they still offer some of the best returns on the market. Unlike penny stocks, promising small caps:

  • File reliable financial statements.
  • Are transparent.
  • Have conference calls that individual investors can listen to.
  • Don't simply hype their stock in press releases.

That's a starting point. There are more -- and more important -- criteria to help you find great small-cap companies. Our team at Motley Fool Hidden Gems, for instance, looks for a balance sheet with lots of cash and no debt, and a tenured CEO (or founder, if possible) who holds a substantial ownership stake in the business. In other words, we're looking for big returns with good old-fashioned bottom-up analysis.

You can view the 50-plus small caps our team has already found with a free 30-day trial. There's no obligation to subscribe, and we particularly recommend it for the penny-stock-o-philes reading in Florida. You know who you are.

Already subscribed to Hidden Gems? Log in at the top of this page.

This article was originally published July 27, 2006. It has been updated.

Tim Hanson and Brian Richards disagree about whether the U.S. Treasury should do away with the penny ... but the Treasury is probably busy with other issues right now. Neither owns shares of any company mentioned. Google and Baidu are Motley Fool Rule Breakers recommendations. The Fool's disclosure policy is finger-lickin' good.

Read/Post Comments (4) | Recommend This Article (41)

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  • Report this Comment On April 19, 2009, at 11:28 AM, ReadThisN0w wrote:

    Insmed actually is NOT your typical pennystock.

    Recently they did a deal with merck for 130 million US dollar.

    Cash rich biotech company after Merck acquired their generic biologics development platform. (1.03$ per share after deal closes)

    Lead pipeline drug is a very complex biologic called IPLEX.

    Iplex occurs naturally in the human body and can induce muscular, neurological and bone growth.

    Iplex has shown effectiveness in short stature in children (fda approved) where it was well tolerated and labeled safe in children.

    Iplex is being researched (amongst others) in adult degenerative lethal illnesses like Myotonic Muscular Dystrophy, Amyotrophic Lateral Sclerosis as well as Retinopathy in infants.

    ALS and MMD are orphan indications. Iplex is priced at a premium due to high past development cost. Orphan indications are mandatory reimbursed for approved indications and have additional market protection.

    Partial building block of Iplex (folding protein igfbp3) has well documented apoptic properties. (ie enhances anti cancer drugs).

    Insmed has opt-in agreements with Ipsen ( .fr ) and Genentech (DNA, .us).

    - Biogenerics platform was sold in february 2009 to Merck for 130 million US dollars (finalizes march '09)

    - Total share count for Insmed: 122 million, cash per share from the deal: 1.03$ per share after taxes

    ( Proceeds for Insmed are 123 million US dollar AFTER taxes )

    - Liabilities end of 2008 6~8million, 2.4 million in cash

    - Cash burn was about 1 million per month prior to the Merck deal

    - Tax los carry forward per dec '07 330 million US dollars.

    - 70 staff will go with the Boulder plant to Merck (of total of 90 TOTAL staff for insmed)

    - 20 staff will remain at Insmeds Richmond HQ.

    - IPLEX pipeline and IP remain

    - IPLEX is allready fda approved for short stature in children

    - IPLEX is researched in europe in retinophathy in infants.

    - IPLEX Myotonic Muscular Dystrophy IIb resuls in Q2 the latest (peak revenue estimates from 600mln-1.3bln)

    - MMD iib results triggers optin from ipsen/genentech (50% of all past and future cost in return for 50% of profits)

    - ALS (Lou Greg) named patient partner to be announced soon

    - Still takeover candidate for Ipsen and/or Genentech

    Further DD items:

  • Report this Comment On April 19, 2009, at 12:54 PM, TideGoesOut wrote:

    Not all "penny stocks" are truly penny stocks either.

    For example, (why do I always come back to this example? Because it's served me very well) Tata Motors (TTM).

    I bought at 3.15 and 3.49...well under the arbitrary $5 definition. However, it's an ADR; a "placeholder" for the real price in a foreign company. That foreign stock (BOM:500570), on the Bombay exchange, is current valued at $236.30. Hardly qualifies.

    That's regarding what I consider a "good" company. For other huge companies that trade under $5/share, look at a screener. Currently on Google Finance's screener there are 50 companies with market cap more than $1 billion that currently trade under $5. Of course, some of those are the really downtrodden (F, C, AIB, AIG). But if I limit it to only those reporting operating margin and net profit margin in positive territory, I still have 10 potentially worthwhile sub-$5 that are not what should be considered "penny stocks".

    A few very wise (and very rich) people have said "ignore the stock price, based your purchase on the quality of the company". I'd addend to that to drop this "penny stock" concept entirely, when based on just the stock price. Market cap is a better definition. Microcap and nanocap stocks are riskier then medium-cap and large-cap, obviously. Neither have anything to do with the cost of an individual share.

  • Report this Comment On April 19, 2009, at 2:13 PM, ayansircar wrote:

    This is an extremely useless article. By the definition of SEC, as has been pointed out - it was more likely to lose your entire worth in C, GM, F etc. than in INSM etc. So, those are worse stocks in this market in correct sense.

    Moreover, I fail to understand the purpose of this article at all! - "Oh! See - the stock went up! Gee - wish I was in it." - yes - we can see that - and you are letting us know the same thing by incorrectly qualifying some stocks as penny stocks solely by share price ?!

    Please, Motley Fool - do some review of articles before publishing worthless ones.

  • Report this Comment On April 21, 2009, at 10:05 AM, ReadThisN0w wrote:

    TA wise on Insmed

    on weekly charts it moved right past the 200 MA

    new 52 week high as well

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