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 Diedrich Coffee (Nasdaq: DDRX  ) , Vanda Pharmaceuticals (Nasdaq: VNDA  ) , or Cell Therapeutics (Nasdaq: CTIC  ) , each of which has returned more than 500% over just the past six months! Neither traded for more than $0.65 per share six months back.

Those quick jumps look like easy gains, considering that CME Group (Nasdaq: CME  ) and PotashCorp (NYSE: POT  ) would need to add more than $270 and $110, respectively, to their share prices to even double.

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 1,870,000" 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 232,000 and 594,000 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 stock price. Going solely on price would wrongly categorize billion-dollar companies Office Depot (NYSE: ODP  ) and Flextronics (Nasdaq: FLEX  ) 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. The Fool's disclosure policy is finger-lickin' good.

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  • Report this Comment On May 21, 2009, at 9:18 PM, kurtdabear wrote:

    Is GM a penny stock? Or AIG, Fannie Mae, Freddie Mac? How about NorTel? I lost my butt on NorTel early in my investing career. I bought on a "dip" after Standard & Poor's issued a 5-star recommendation just before their first set of officers were hauled to jail in handcuffs. It went from 40 to 50 -- $40 to 50 cents!

    A company is what it is. GM is a penny stock due to really lousy management, as are the rest I listed above.

    But I more than tripled my money in Northgate Exploration buying it many years ago, when it was still in the pink sheets, because it had excellent management--same with Taseko Copper (416%). Others were good "special situations," like Gold Eagle Mines (2200%) and Nucryst Pharmaceuticals (4600%). (As you say, that kind of pop is a real thrill.)

    Not all work out, but a stock that goes from "20" to "60" is still a triple whether that's priced in dollars or cents. And a company that has no debt, operates profitably and has millions in assets is better than a money-losing "Blue Chip" with billions in assets and trillions in liabilities.

    As long as you understand the rules and the situation, it's still the old formula of risk vs. reward.

  • Report this Comment On June 06, 2009, at 3:07 PM, ALLYMAT wrote:

    LOOKING FOR SOME GOOD PENNY STOCK.WANT TO PLAY WITH $10,000.00 and day trade.someone help me herman298@hotmail,com

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