For novice investors and more experienced ones alike, there's something inherently tempting about a company with a very low stock price. If XYZ Corp. is trading at just $0.50 a share, it only needs to go up $0.50 a share to double your investment. Netflix moves more than that every day. And what if XYZ turns out to be the next Netflix? Buy now, and you could get super-rich, right?
Well, no. Step away from the keyboard. Do not press buy. Do not invest $200. (Or, worse, $2,000.)
In this mailbag segment from the Rule Breaker Investing podcast, host and Motley Fool co-founder David Gardner and guest David Kretzmann, head of Motley Fool Asia, explain to a smart and forward-thinking college student why he shouldn't be using penny stocks and short-term trading as his entry to the world of investing.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
This video was recorded on April 24, 2019.
David Gardner: Let's pick it up with No. 7. Then this one comes from Aaron Howard. "Hello. I'm Aaron Howard. I'm a full-time college student at Goldey-Beacom College, so I have a limit to my finances and how much I can invest. I've recently taken an interest in investing. I've listened to some David Gardner podcasts, read a few articles on fool.com. I did research, read the article about which broker to use. I feel as if Ally is one of the best for my situation due to the no minimum and low fees portrayed." Good job doing your homework there, Aaron!
He says, "I would like to invest in both short-term and long-term stocks. Long-term as in a Roth IRA, but I'm also very interested in short-term quick return stocks with little returns on each before I start investing into long-term stocks. The most recent article I read on fool.com says to stay away from penny stocks. My issue is, I want to learn the market and the ins and outs, do my own trading. I feel penny stocks will give me a decent feel for the market with my given financial status. I know this sounds like a bad idea for a college student, but I have been a 4.0 student my whole life, and I feel as if I have the drive and adaptability to learn the patterns and ideas needed to succeed. Any help you can give would be much appreciated, Aaron Howard."
David Kretzmann: Boy! Penny stocks are interesting territory. Most beginners will at least be intrigued by the idea of trading penny stocks, trying to find patterns in the chart, whether it's a yakking camel, or I don't know, whatever it is --
Gardner: It doesn't matter, because if the stock is at $0.37 a share, David, if it goes to $1, you've more than doubled your money, right? That is the mentality. I had that, too, when I was just starting out investing. Did you?
Kretzmann: Yeah. The idea is, if a stock is at $0.37, it's easier for a $0.37 stock to go to $1 than it is for a $37 stock to go to $100. In reality, that's not the case. What counts is the overall value of a company. Just because Amazon is at $1,800 a share or so as we tape this, it doesn't mean it's any less likely to go to $3,600. What counts is the overall total value of the company.
Gardner: Why don't we like penny stocks, typically?
Kretzmann: Typically, penny stocks are trading for pennies for a reason. You have to remember, behind every stock there is a company. With penny stocks, typically the companies aren't in that great of shape, if they're even selling a product or generating revenue. Oftentimes, they're losing a lot of money, they don't have much of a track record. A lot of shady stuff can be happening with penny stocks.
Gardner: It isn't to say that it always will. There are certainly some fine micro-cap companies and some fine micro-cap investors. But I do agree with you, David. When you're talking about a stock that you could double if it just went up from $0.37 to $0.74, and it's very thinly traded, it might be a promotional company that's hired somebody to market their stock for them. Then word gets out on the internet, "This one could go from $0.37 to $0.74!" Markets can move like that, and sometimes people take advantage, bad actors are in there taking advantage of that.
Kretzmann: Yeah, pump and dump schemes that are out there. People will front-run their email list or their members, buy up a lot of this stock, then heavily promote it to the public, even taking out advertising to promote this stock, send it out to their email list --
Gardner: And then be selling their shares to the people who are buying.
Kretzmann: Yeah. Inevitably, that will crash and burn. The track record with penny stocks are murky at best. I haven't found anyone who has a long-term track record of success when it comes to identifying patterns, any sort of meaningful success over the long run when it comes to penny stocks.
Gardner: We do talk a lot about market cap on this show. Somebody might be wondering, what's a penny stock? What's a micro-cap? What are the differences? For me, I'd make up that micro-caps are anything below $250 million of market cap, that or less. When you get down in Penny Stockville, I almost think that's its own separate asset class. I'd say sub $50 million at that point. Often, it's very thinly traded stocks. There aren't many shares.
But beyond what a penny stock or micro-cap is, David, for me, these are usually companies that aren't really impactful in the world at large. They're not really doing important things, are they, if their stock is all the way down there at $0.37 a share. I think we've done much better as investors ourselves, as Rule Breakers, finding the real impact players in the world at large. Those are usually the stocks you can hold for three-plus years.
Before we go on to Rule Breaker mailbag item No. 8, Aaron is talking about this concept of short-term investing. Let's pretend it's not even about penny stocks. Did you ever do that, trade in, trade out, alongside a longer-term approach to investing?
Kretzmann: I've definitely dabbled with that. I don't do it as much because again, it's hard to generate any sort of meaningful consistency with that type of strategy. I think as humans, we're susceptible to being overconfident. We think we're better than we really are.
Gardner: Do you think that's true of some of the Game of Thrones characters?
Kretzmann: Probably so, yeah.
Gardner: I think some of them definitely -- Cersei -- think that they're better than they really are.
Kretzmann: Yeah. Might come back to bite them in the next four episodes. [laughs] But, yeah, with short-term trading, any time prize and that's less than one year, you're really flipping a coin. Sometimes you'll get lucky, you will be right on the money, the stock will go up like you anticipated. But for the most part, I've found that I do far better the longer I extend my time horizon. Even if you're starting with smaller amounts as a student, like Aaron is, I think you're going to be far better off long-term if you don't dabble in the trading and focus more on what can you do to extend your time horizon, and find a great business that you think will be more relevant 10, 20 years from now. Buy as many of those types of companies as you can and just hold voraciously. I think you'll be a lot better off.
Gardner: We want to close by praising Aaron for even getting started investing, for his curiosity, for his 4.0, and for wanting to really lean into this subject. I think it's fine to act on an initial urge if you like to be a little shorter-term. I wouldn't put a lot of money in it. But some people enjoy their fun money at Las Vegas. You could do short-term trading stocks if you wanted, and maybe learn something about the market dynamics. But I think most of us, the earlier the day comes where we realize, "I'm in it for life as a long-term player," that's when our real returns start coming. So I would encourage you, Aaron, to think about that side of the equation far more than the short-term.