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Are Penny Stocks Really That Good?

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It's hard to argue against the allure of penny stocks. Controlling hundreds if not thousands of shares of a stock for relatively very little money means if it goes up just a nickel or dime in value you'll make a killing.

A penny for your thoughts
The Securities and Exchange Commission considers any stock trading for less than $5 a share to be a "penny stock." So right now, financial services giant Citigroup, at just more than $4 a share, is technically a penny stock, though most people think of them as trading for less than a dollar.

Yet you can get some spectacular returns at both ends of the spectrum. For example, Chinese wastewater treatment equipment maker RINO International (Nasdaq: RINO  ) started 2009 trading at $3.50, but closed it out at $27.65 -- a 700% increase. Human Genome Sciences (Nasdaq: HGSI  ) went from $2.12 at the end of 2008 to $30.58 one year later.

At the other end, mattress maker Select Comfort jumped from just $0.25 per share at the start of last year to more than $6 a stub by the end of it, and RF Micro Devices (Nasdaq: RFMD  ) traded for less than a dollar a share at the end of 2008, only to jump to $4.77 by the end of the following year.

The $64,000 question
Does that mean penny stocks are a good investment? Is there a newsletter opportunity here for The Motley Fool?

That's what @STATiano wanted to know when he asked the Fool on its Twitter feed: "?..I do penny stocks.. 09' was my 1st yr and it was awesome.. 10' not so much..Was 2009 an unusually good year for pennys?"

While last year may have been a good year for penny stocks, you can find low-priced wonders anytime. In 2008, paper products specialist Boise (NYSE: BZ  ) went from $0.43 a share to $5.31, a better than 1100% return, while business development company American Capital (Nasdaq: ACAS  ) has more than doubled in value so far this year.

It's not so much the time frame of when they were trading, but what they were bringing to the table. Although American Capital and Select Comfort were trading for pennies on the dollar and had fallen on hard times because of the recession -- who wants to buy a $5,000 bed when your house is being foreclosed on and you're in danger of losing your job? -- they were still real businesses with actual goods and products to sell in the marketplace.

A den of thieves
Far too often you'll find real penny stocks are simply a story, typically whatever is hot at the moment. Is renewable energy in? Then penny stocks will be populated with companies going to become the next First Solar (Nasdaq: FSLR  ) . Was there a huge discovery of rare earth metals in Afghanistan? Watch the rush to be the biggest lithium producer this side of Chemical & Mining Co. of Chile (NYSE: SQM  ) . Is gold hot? Then gold mining stocks will be where they're at (OK, gold mining penny stocks seem to be a perennial favorite).

The point is, if they're not outright scams then they're little more than shell companies with a business plan. Read through their SEC filings, and you'll see they're long on what they're going to do and very short on accomplishments. Indeed, most probably don't have revenues or even a product. It's forever under development, and only by raising more money by issuing shares will they survive.

And just as you're buying in the insiders will cash out their shares to recoup their own investment, leaving you holding worthless pieces of paper.

A penny saved
Putting your money into a company with nothing to go on other than hype or hope is not investing, but gambling -- which probably explains why there are very few people who have been able to consistently trade penny stocks profitably.

Yes, penny stocks can be exciting, but you should have all of your money working hard for you all the time. While many investors take a flier on some speculative venture for the fun of it, they're playing a game with the odds stacked against them. So no matter the year, avoid penny stocks at all costs.

If you're looking for excitement without the hype, check out who the folks at Motley Fool Rule Breakers have recommended, like First Solar. There are no penny stocks or fly-by-night operations here, just good, solid companies with exciting long-term growth potential. You can try it risk-free for 30 days.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.

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  • Report this Comment On August 04, 2010, at 1:16 PM, CMFStan8331 wrote:

    So many, if not most, penny stocks are bad investments. Seems to me that the answer - rather than blindly running away in fear of the entire sub $5 category and missing out on the huge potential profits that the best low-price stocks can offer - is to find a way to access solid, reliable information about these stocks. Something along the lines of CAPS and TMF, perhaps?

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