Beware of Penny-Stock Profits

Penny stocks have cleaned up lately. Two hundred U.S. stocks with market caps over $200 million have tripled or more in the past six months, and of those, nearly 80% of those triples traded at $5 or less per share in late February. Here's a selection of February's penny stocks and their recent fates:

Company

6-Month Gain

Current Share Price

CAPS Rating (out of 5)

Avis Budget Group (NYSE: CAR  )

2,339%

$10.73

*

Human Genome Sciences (Nasdaq: HGSI  )

951%

$20.50

*

Vonage Holdings (NYSE: VG  )

503%

$2.17

*

Sirius XM Radio (Nasdaq: SIRI  )

407%

$0.66

**

Ford Motor (NYSE: F  )

284%

$7.61

**

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

Look at those juicy returns!
Wow! It's rare to see dozens of stocks rising that much so quickly all at once. We all really should've been buying penny stocks, right?

Not so fast. Remember that late February was arguably the darkest hour of this recession. The global financial system looked ready to topple if you looked at it crosswise. Ford traded at $1.98 a share; Avis stock changed hands for $0.44 a stub. These stocks were priced so that as long as the companies survived, the shares would go up. But back then, whether they'd survive at all was far from certain.

Pitfalls and pratfalls
In addition, just looking at penny-stock winners only gives you half the story. Some household names that traded at low levels for months, such as Circuit City, have gone out of business entirely. Many more are in bankruptcy, including paper giant AbitibiBowater and theme-park veteran Six Flags, and their shares will likely be worthless. Often, penny stocks simply never recover.

Those that do recover, however, often need extraordinary events to help them out of their troubles. Consider:

  • Human Genome Sciences got a critical FDA approval for a Lupus drug developed together with British pharma titan GlaxoSmithKline (NYSE: GSK  ) .
  • Avis landed some much-needed financing, and then business started picking up.
  • Ford bucked the trend of American car company bankruptcies and has gotten some big help recently from Cash for Clunkers.

Six months ago, could you have foreseen all that happening?

Moreover, many of these and other penny-stock winners are still extremely speculative. Sirius may still collapse under a capital-intensive business model. Vonage has quadrupled in the last week alone, perhaps thanks to news about Google (Nasdaq: GOOG  ) and its Google Voice application, but no one knows for sure what pushed shares higher -- or whether they'll stay there.

Recent gains have made penny stocks look tempting, but don't let their recent success fool you. Buying a penny stock is a gamble on a bounce-back that often never comes. If after extensive research, you're not convinced that the rewards are worth the risk, then you're better off steering clear.

Penny stocks aren't the only way to seek huge gains. Grab a free 30-day trial pass to our small-cap investing service, Motley Fool Hidden Gems, and find small companies with big potential.

Fool contributor Anders Bylund owns shares in Vonage and Google, but he holds no other position in any of the companies discussed here. He'd pay good money for an account with Google Voice plus Vonage. You can check out Anders' holdings or a concise bio if you like. Google is a Motley Fool Rule Breakers selection. The Motley Fool is investors writing for investors.


Read/Post Comments (18) | Recommend This Article (22)

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 August 27, 2009, at 4:26 PM, BigVincent wrote:

    Double down on the penny and get rich quick. Don't believe the hype.

    Inflation is at all time highs and intrest rates are at there lowest. You will make more money in the penny stock, then any other stock available to date.

    you get more for your dollar in penny stocks. If bankruptcy is preventable share price goes up.

  • Report this Comment On August 27, 2009, at 4:37 PM, vairman wrote:

    Sure, bash Sirius stock again, as you always do. The company will not collapse and yet, you put this "opinion" out there without any facts to back it up. Just more babble from fools.

  • Report this Comment On August 27, 2009, at 4:54 PM, JRSmithman wrote:

    I think if we all boycot Fools they will become penny journalism? everyone dont respond to anymore of these scare tactics.

  • Report this Comment On August 27, 2009, at 4:57 PM, JRSmithman wrote:

    and by the way Siri is a 3 star cap according to S&P with an upgrade from CCC+ to B- fools dont count as real stock analysis

  • Report this Comment On August 27, 2009, at 4:59 PM, JRSmithman wrote:

    lol Ford is grouped with Siri in star caps / lets see one is over 7.00 and rising Siri is .69 hmm

  • Report this Comment On August 27, 2009, at 5:00 PM, JRSmithman wrote:

    and lets see what else is completly wrong here you all posted this report with siri being .66 its .69 stop quoting yourselves from the past

  • Report this Comment On August 27, 2009, at 5:41 PM, ST0CKTRADER wrote:

    another siri bash from motley fools, i think it's because the boat has set sail and they missed their ride. there are no repeats FOOLS!

  • Report this Comment On August 27, 2009, at 6:19 PM, Ericscam22 wrote:

    Ford is an incredible value. The company ain't going nowhere. It will hit 12 by the end of the year, or higher. And that ain't speculation.

  • Report this Comment On August 27, 2009, at 6:25 PM, Fredlee009 wrote:

    Congratulation, you now have the stupidest article title in history. Profits are profits, I really dont think anyone needs to be afraid of profits. LOL LOL

    LOL

    LOL

    Profits are great, I know personally I am not afraid of them.

  • Report this Comment On August 27, 2009, at 6:32 PM, trammen0 wrote:

    You guys are pretty smart... Tell people to stay away from stocks that have 400% gains and you have been saying this for months.. To all the idiots that actually do what this FOOLISH article says you lost alot of profits now didn't you!!!!!!!!

  • Report this Comment On August 27, 2009, at 7:12 PM, sluggo32 wrote:

    Interesting about small cap stocks, they can't go down that far to really hurt you, yet they are cheap for a reason. Not necessarily that they will go out of business, just not doing well or heavily in debt. Human Genome is an interesting example of why Motley Fool didn't get this one right. They did not get an FDA approval for their Lupus drug, it is pending in November. Had they gotten approval, a $30 target is most likely. Fool, get your facts straight.

    On another topic, I paid my $199 to get info from MF and instead, I get an email with some info and a barrage of other solicitations from them, that I thought should be included in the original subscription. I wrote them and never got an answer.

  • Report this Comment On August 27, 2009, at 9:10 PM, doublexx wrote:

    Why pay 199 for fool bs or any other paid picks when you can get great picks from covestor.com for free and the traders track record are verfied . Just find a trader with a good track record that fits your risk tolarence and buy the same stocks.

  • Report this Comment On August 28, 2009, at 5:54 AM, gt7255 wrote:

    Doing the opposite of you fool's advice is quite profitable. I give you -5 stars.

  • Report this Comment On August 28, 2009, at 9:54 AM, Joelshann wrote:

    I'm really quite saddened by the way some of the responses--here and, more broadly, on other stock boards--bypass a critique of the article on the material presented and stoop to attacking the author.

    Of the 23 posts above--ignoring the needless repetition of one poster--stupid, stuck, and fool are terms leveled at the author.

    Heck--I don't knw this author. I don't agree with his assessment of the stocks. The opportunity for us as a community of traders is to show WHY (factually, fundamentally) our perspective differs. One wins more followers, and posts become valuable. It seems the internet (and anonymity) have chipped away at the final restraints of basic human respect.

    Some suggested they boycott the Fool. There are two ways to do that: one--post sound analysis of reasoning (Keynesianor Austrian) of your assessment, take a trading position and stand by the results, and win enough followers to start your own boards...or (two) simply chose to take the ad hominem language elsewhere.

    I hoping for the first, and invite you to the party.

  • Report this Comment On August 28, 2009, at 3:45 PM, IntrepidJosh wrote:

    Hmmm, to the contrary... I did my research when the time was right. Hopped on CAR back in April with 4K and the total grew to over 20k in 4-5 months time... I got out my initial investment, letting the gain ride and have already reinvested the initial in another so-called penny stock(s). It seems that the FOOLS are urging more caution about investing in this category over other categories... if you use the same prudent judgement you would with all your investment decisions you can capitalize nicely... In fact, I'm beginning to focus more on the Penny than ever before.

  • Report this Comment On August 28, 2009, at 4:52 PM, beawinner2 wrote:

    Nothing to MF anymore, everyone knows it.

    Too Bad.

    I want my money back, even the coments aren't worth reading anymore.

    Do writers get a cut of the referals?

  • Report this Comment On August 28, 2009, at 9:41 PM, ozzfan1317 wrote:

    Another site the dissenters should check out.

    www.newsecretsoftherich.com

  • Report this Comment On September 01, 2009, at 1:20 PM, BullishBroker74 wrote:

    Brandon Matthews

    On any given day, there are dozens of professional stock “bashers” trolling the stock message boards and posting erroneous information on Sirius XM Radio (SIRI). Perhaps that is where Jim Cramer, CNBC and the multitude of biased financial media get their information, so with that in mind I set out to dispel some of the myths surrounding the company, by explaining the reality of things like revenue, debt and EBITDA growth.

    Our first myth involves Sirius XM debt and the battle cry of the ignorant that it is somehow excessive. As the chart I’ve embed below indicates, Sirius XM debt stands at $3.89 billion. Compare that figure to Viacom (VIA.B) at $7.37 billon, Comcast (CMCSA) at $33.04 billion, Dish Network (DISH) at $5.13 billion, Time Warner Cable (TWC) at $22.93 billion, British Sky Broadcasting (BSY) at $4.46 billion or even Direct TV (DTV) at $5.79 billion and clearly Sirius XM Radio debt is anything but excessive. [click to enlarge]

    How many times have we heard the argument that Sirius XM Radio has too many shares outstanding? First of all, there is no such thing. A company’s value is not measured in outstanding shares but rather its market cap. Once a company achieves positive free cash flow and sufficient earnings, shares can be repurchased, and Sirius XM Radio has many years ahead of it in which to implement such a plan. There are some who question the potential market cap of Sirius XM Radio. The problem is that Sirius XM Radio suffers from an identity crisis. One analyst may value the company based on media stocks, while another labels the equity consumer discretionary, while still others like myself look at the company as a subscription service like cable operators.

    Sirius XM Radio has a current market cap of $2.69 billion dollars, and commanded a combined market cap of as much as 6 billion dollars just one year ago. Compare that figure to Viacom with a $15.27 billion market cap, Comcast with $45.08 billion and Direct TV with $24.37 billion, and clearly there remains plenty of upside potential to SIRI shares.

    Based on current valuations, Sirius XM is being lumped with companies such as Clear Channel (CCO) which commands a market cap of $2.5 billion as it faces the potential of bankruptcy in the not too distant future, and which derives almost all of its revenue from advertising. It is for this reason that Sirius XM Radio shares remain undervalued and explains why some retain their negative outlook on the stock. Sirius XM Radio would be fairly valued today at $1.30 – $1.50 per share based on its debt management and increased year end EBITDA projections.

    What about Sirius XM’s future potential? Of all the stocks mentioned above, I would like to direct your attention to revenue growth. Sirius XM’s revenue growth stands at 108%, dwarfing all of the competition, and analysts expect revenue to continue to grow over 60% in 2010. As my friend “Muscle13″ points out, it’s all about EBITDA growth. It is also the one metric that critics can point to in justification of their negative bias. Even with increased EBITDA guidance, Sirius XM still falls short of having earned a higher market cap than the 6 billion it should currently be valued at. As the chart shows, the market cap values of the other company’s mentioned far surpass that of Sirius XM based on EBITDA. That is changing to the positive however, as Standard & Poors research points out in their research report:

    (Sirius XM) Management recently issued post-merger financial targets for the next five years, with 2009 subscriber growth of 20.6 million reaching 28.4 million by 2013, revenue of $2.7 billion to $4.1 billion, adjusted EBITDA of over $300 million to $1.5 billion, and free cash flow of breakeven to $1.4 billion.

    Sirius XM management had provided 5 year guidance which offers the potential of Sirius XM shares rising to as much as $7.50 in the next 5 years, as long as management can deliver. Those projections put EBITDA at 5 times its current level. Simple math tells us that $1.50 x 5 = $7.50. That’s not a bad 5 year potential return on a .65 – .70 investment and certainly a justifiable long term price target that leaves out any outrageous multiples that a sector monopoly might warrant in the future.

    There is one more myth that is beginning to make its way around the web. That is a claim that Sirius XM will soon receive a delisting notice. That is false. They will soon receive a letter of non-compliance and have at least a full year to regain compliance.

    Position: Long SIRI

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