If you play Motley Fool CAPS, you might be forgiven for thinking that CAPS stands for "crush all penny stocks." What is CAPS? It's this amazing free tool at the Motley Fool. It works like this: You pick stocks that you think will beat the market. And the CAPS software measures how your stock pick does versus the S&P 500.
Almost 60,000 Fools have been playing CAPS for almost 15 years now. One of the things that CAPS has taught me is that if you buy and hold fast-growing innovative companies (i.e. Rule Breakers), you'll be wrong a lot. But your winners will absolutely kill the market, and overall you will, too. So definitely you should play CAPS, and test your stock calls against those of all the others in the Fool universe.
But there is one danger in CAPS that I want to highlight. In CAPS, some of the very best players have gotten to the top by shorting awful micro caps. Is that the best strategy in the actual stock market? No! In fact, it's a horrible strategy. Here's why.
1. Money, money, money, and money
In CAPS, we're just giving our opinions about what stocks are going up and what stocks are going down. So in that universe, where it's just ideas, the very best investment plan is to short awful penny stocks while simultaneously going long on the S&P 500. That's absolutely the best winning strategy. CAPS has proven it.
But CAPS is a game that measures our opinions, whether we are right or wrong on a stock. In real life, we're investing dollars. And the introduction of money changes the dynamics of whether your opinion is right or wrong.
That's because of the way a "short" is structured. You're not just giving your opinion that a company is bad and its stock is going down. You're simultaneously going into debt in order to short a company. You're borrowing the shares from your brokerage. And now you owe your broker money.
It's the debt that makes shorting a dangerous strategy. You owe your brokerage money now, which makes you vulnerable. You have an obligation to pay back this debt. If the stock goes up, your broker will ask you for more money. If you can't come up with the money, your broker will close out your position at a loss. This common maneuver, known as a short squeeze, happens every day.
2. Penny stocks are thinly traded
Penny stocks are horrible investments. Once in a blue moon, a micro cap will emerge from obscurity and give you a truly amazing return. I had this experience with Novavax (NVAX 2.82%) in 2020, which was a lot of fun. But it was a highly risky stock, and so my position was tiny at first.
At least Novavax was trading on a major exchange. (It had to do a 20-for-1 reverse split to stay up there!) The company wanted to avoid delisting because that is usually the kiss of death. Most investors stick with the New York Stock Exchange and the NASDAQ, and avoid the pink sheets except when buying an ADR of a major foreign company. Sometimes you will have micro-cap investment opportunities on major exchanges, like Novavax. So you might want to limit yourself to that cohort if you want to risk it. (And micro caps are extremely risky).
It doesn't follow from this that shorting a penny stock is a brilliant idea. Even if 99% of penny stocks are horrible investments, that's a long-term phenomenon. In the short term, a penny stock can make dramatic moves up or down. A market maker can look at the short interest and decide to double the stock price of a penny stock today. Which is fairly easy to do if the float is small. All of a sudden your position is precarious and you are forced to pay money to your brokerage, or else.
Traders can easily manipulate a penny stock. You can be completely right on your analysis of the stock, and the company's future. It can be a horrible company, and its valuation can be ridiculous. But your debt to your brokerage often makes your long-term thesis irrelevant. You're looking at the forest and the tree smacks you in the head.
3. Long and strong is the best strategy where money is concerned
The stock market rewards positivity and optimism. You want to evaluate the risks and avoid stupid ones. However, if you own shares in top dogs and first movers in important emerging industries, the math really is on your side. Over time your winners will absolutely crush the market and make you forget about all your bad stocks that lost money.
As a bull, all you can lose is 100% on any particular stock. Meanwhile, your upside can zoom past 100%, or even 1,000%, and you might even pass 10,000%.
It's the miracle of compounding returns that makes this happen. You want to be on the right side of compounding. Debt puts you on the wrong side. That's why margin is bad. And shorting a stock is a dangerous move for the same reason. And if you're shorting penny stocks that are thinly traded, short-term trading strategies will often negate your long-term thesis.
In short, if you're relying on debt to get ahead, the odds are against you, and as you rack up debt you're really going to get killed.