Why Penny Stocks Are a Bad Move

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Small stocks can offer opportunities for big rewards. But with really small stocks -- also known as penny stocks -- the risks involved often outweigh any benefits.

Penny stocks aren't the kinds of shares that can make you a millionaire. You'll find many of them trading for less than $1 apiece -- hence the name. Unfortunately, they usually fetch such tiny prices for good reason. Typically, penny stocks have relatively few shares outstanding, making it easy for fraudsters to buy shares, hype up the company, and thereby drive up the price as others flock in. Then they'll sell their shares, sending the stock cratering again -- a classic example of "pump and dump."

Engage in resistance training
Even if you know that, you can still get lured in by the hype. Here are some choice excerpts from a dubious email that recently urged me to buy into an energy company:

  • The company supposedly controls some 150 square miles of "key petroleum leases" near the oil-rich North Sea. Note that the company's not boasting that it's actually discovered oil -- just that it's near the place where billions of barrels "discovered by BP (NYSE: BP  ) and now operated by Apache (NYSE: APA  ) " were found.
  • In a single paragraph, the company claims that its four license blocks are estimated to contain a prospective resource of approximately 236 million barrels of oil. This "pending discovery-size" is apparently good, because it puts the company's supposed prospective oil holdings in the "highest potential" areas in the U.K. Did you catch any certainty there? Any specificity? Any proven assets?
  • The company is actually producing oil in Texas, via a lease near some oil discovered by Royal Dutch Shell (NYSE: RDS-A).

That's all classic penny-stock stuff. The hypesters get you excited with possibilities -- possible cures for cancer, possible gold mines, possible billions of barrels of oil. But why take such wild chances with your money, when you can invest in proven companies that can dominate their peers?

Lying low
To check the email's claims, I looked up the company. Until recently, you wouldn't have found much information on it. Before the email spurred investor interest, the stock went days without trading at all. Even now, days where more than 50,000 shares trade are rare. At just more than $1 a share, that's not very significant -- especially when you compare it to the hundreds of millions of shares traded daily for active stocks such as Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) .

Don't let yourself be tempted. While the stock hyped in the email I received has skyrocketed since this marketing push, in the long run I think it'll more likely trade for $0.10 than $10. Focus instead on powerful companies with compelling advantages.

Longtime Fool contributor Selena Maranjian doesn't own shares of the companies mentioned in this article. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.

Read/Post Comments (3) | Recommend This Article (2)

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 11:22 AM, topsecret10 wrote:

    Microsoft once traded at 25 cents. International Remote Imaging once traded (IRIS) traded at 12 cents In 2001,the stock has since hit $22.00 and Is currently over $11.00.... There are many penny stocks that have done the same over time. Research Is the key,especially with micro-caps.... How about a FOUR BAGGER In 7 trading days.........

  • Report this Comment On February 24, 2010, at 11:35 AM, topsecret10 wrote:


  • Report this Comment On February 24, 2010, at 12:27 PM, kurtdabear wrote:

    So you take one piece of junk mail and go from that specific case to a general diatribe against all "penny stocks?"

    How about allowances for cultural differences, such as the fact that British investors and many Commonwealth nations prefer low-priced stocks?

    How about the idea that maybe something besides price is the determining factor in good or bad investments?

    For instance, maybe you should be wary of investments that come to you. Just as you got the piece in the mail, you could get a call from your major Wall Street broker inviting you to get in on a hot IPO. Are you aware that more than 90% of IPO's are worth less a year after their issue date than on their issue date?

    Maybe what the problem is is that good investments don't come to you; you have to work hard to find them. Price should not be your paramount concern.

    For instance, a few minutes ago I read another Fool article extolling the virtues of Northgate Minerals. I first started buying NXG a decade ago when it was in the pink sheets--a penny stock. I tripled my money. I bought more in Dec. '08 when it fell to around 60 cents in the depths of the market's gloom. Again it was a penny stock, despite having grown and becoming listed on the AMEX. This time I quintupled my money.

    Also last year, I did quite well in a small pharmaceutical company that was selling for less than its cash per share. It was selling around 75 cents a share when I bought it but had $1.25 per share in cash. Was it a penny stock? By price, yes; by cash value, no. At the request of a large shareholder, the company then made a cash distribution of 80 cents a share. That left me with a cost basis of less than zero, so when the company was bought out last month at $1.76 a share, my gains were incalculable in percentage terms.

    One of my worst disasters came from buying Nortel, which was being recommended by about six million "professional" brokers and had top ratings from "independent" analyst S&P for quality and timeliness. I paid $41 a share, and after the CEO and CFO were led away in handcuffs, those shares were worth less than $1. They recovered a bit, then the new slate of officers was led away in handcuffs. This is not that uncommon. Look at Enron and Worldcom. But just plain inept management is more common than crooks--AIG, Freddie Mac, Fannie Mae, Countrywide, Washington Mutual, Wachovia--the list of expensive disasters goes on and on.

    Price is only one factor in a stock's quality, and it should be viewed in conjunction with all the other things you'd normally check in a stock.

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