Companies with stock trading below $5 per share and with very small market capitalizations are often referred to as "penny stocks," and they tend to attract investors who are willing to assume big risk in pursuit of explosive returns. The appeal of stocks that look cheap (at least on paper) and could hypothetically post huge gains is easy enough to understand, and some people might find it even more enticing as the U.S. deals with tougher economic conditions on the heels of the novel coronavirus pandemic.
However, investing in penny stocks rarely works out in the long run -- and it's even riskier during a recession. If you're looking for worthwhile buying opportunities amid market volatility, spare yourself some headaches and heartbreak by skipping the penny stocks and seeking out more prudent strategies.
There's usually a good reason shares are "cheap"
Penny stocks tend to trade at low valuations because the underlying businesses aren't in good shape or there's little visibility into their operations and outlook. It is possible to find companies in the penny-stock category that go on to post strong business performance and great stock returns, but the odds are stacked against you.
Buying penny stocks tends to have more in common with gambling than with principled, well-reasoned investing. Companies in the category often have weak balance sheets, generate little in the way of revenue or earnings, and are typically speculatively valued. These types of companies are especially prone to folding amid the heightened operating pressures created in a recession.
Penny stocks also usually trade over the counter (OTC) instead of on major exchanges like the Nasdaq or the New York Stock Exchange, and that means they might not be subject to reporting requirements and other standards that give investors a greater deal of visibility into business operations and financial status. The lack of regulation and oversight makes it easier for companies to engage in fraudulent practices and leave investors high and dry, and low trading volumes for penny stocks on OTC markets pave the way for potential pump-and-dump schemes orchestrated by third parties.
Recessions heighten the importance of focusing on great companies
With more than 40 million Americans having already filed jobless claims since the coronavirus pandemic began disrupting the country's operations in mid-March, investors should assess the possibility that they might see their income streams interrupted. They should also be weighing the possibility that weakened economic conditions will lead to continued volatility for stocks. Market sell-offs in a recession can create opportunities to build stock positions at significantly cheaper prices, but prudent investors will chart strategies with their personal financial situations and overall economic conditions firmly in mind.
Penny stocks are very risky, and it's important to recognize that they put you at a heightened risk of losing the entirety of your investment. Some investors might mistakenly think that they can embrace high levels of risk because they expect to have steady income from employment, other investments, or dividends -- only for their financial situation to change in short order. The prospect of penny-stock investments losing most (or even all) of their value might seem manageable under normal circumstances, but the impact of large losses changes dramatically if you suddenly find yourself with reduced employment or otherwise face unexpected financial hardship.
What should you look for instead?
Investors looking to buy potentially explosive stocks in a recession can ignore penny stocks and still have plenty of candidates to choose from. Focusing on small-cap companies that have competitive advantages or operate in business sectors that are primed for big growth can allow risk-tolerant investors to record huge gains without embracing the disproportionate downsides that come with penny stocks.
High-growth areas including cybersecurity, fintech, and biotech are just a few industries that play host to many stocks that could deliver fantastic gains for investors. Companies in emerging markets might also offer greater return potential because relative economic growth in these territories is occurring at a faster rate than in the U.S.
Less-risk-tolerant investors who are drawn to penny stocks based on the premise that companies trading at low-pure dollar prices are likely undervalued should discard that notion entirely. A company that trades at $1 per share might look like a steal, but it's important to remember that the stock's trajectory is tied to sales and earnings performance and outlook. Looking at price alone won't tell you much at all about a potential investment.
If a stock's underlying business does nothing but lose money or if hyped-up projects or mission statements never come to fruition, shares purchased at "low" prices can quickly be recast as hugely expensive investing missteps. Value seekers will be much better served by looking for companies that might have lost some luster in the eyes of the market but still offer meaningful competitive advantages, solid balance sheets, or established histories of returning cash to shareholders. The telecommunications, energy, and travel industries can make for worthwhile starting points if you're on the hunt for discounted companies with rebound potential.
Regardless of where you personally fall on the risk-tolerance continuum, avoiding penny stocks in a recession is a move that's likely to work in your favor. The lure of big, quick gains or finding a stock that looks like it could barely go lower might be tempting, but you'll get much better results from a more patient approach and limiting your investing to quality companies.