Who's Afraid of a Penny Stock?

If you're looking for more than index-like returns, you'll have to successfully navigate the market's ongoing fear-to-greed continuum. Lucky for us, few corners of the market invoke more unnecessary fear and blind greed than the perceived dark alley of penny stocks.

Warning! If the idea of investing in a penny stock scares you to death, makes your stomach turn, or makes you want to run for the hills, please, please, please, stop reading this right now.

I offer this warning because it's true, the novice investor should never, ever invest in a penny stock, period. However, if you are among those whom Benjamin Graham called an "enterprising investor," who is able to discern share price from the true value of an enterprise, we can talk.

Penny stocks vs. worthless companies
The Securities and Exchange Commission broadly defines "penny stocks" as low-priced (below $5), speculative securities of very small companies. True, many of them don't file financial reports with the SEC, have limited operating histories, and hold little to no reportable assets. The average microcap stock that the SEC suspended trading in had roughly $6 million in net tangible assets -- and nearly half had less than $1.25 million.

While most of these stocks are indeed garbage, a fair number of low-priced stocks trade on traditional securities exchanges and do provide up-to-date financials. Most rookie investors have either been scared off or burned so badly by penny-stock speculation that they have summarily sworn off any and all companies with single-digit share prices.

But we know that whenever other investors make blanket assumptions based solely on emotion or without evaluating evidence contrary to their beliefs, market mispricing often follows. And because institutional investors also generally ignore low-priced stocks, it remains a stocked pond for fishing out opportunistic values.

A basic stock screen for stocks trading on major U.S. exchanges for less than $5 produces about 1,500 candidates. Digging deeper, 131 of these companies have market caps above $500 million, a majority of which (89) are bigger than $1 billion.

Recognize these names?

Data from Capital IQ, a division of Standard & Poor's.

This just goes to show that all penny stocks are not created equal.

Being a penny stock doesn't automatically mean that it's not a real operating company with a viable business model. Usually, these are companies that have fallen on hard times -- whether it's a burdensome debt load, share dilution, negative industry trend, or the loss of a major client. The trick is separating the underdogs from the dead ducks.

Pitching pennies
Even some of the best small-cap managers in the world aren't scared to invest in penny stocks, either. Bruce Berkowitz -- investing legend in the making -- stops to pick up the occasional penny. Recently, he's been actively accumulating shares in Citigroup for his Fairholme Fund (FAIRX) -- a fund with 13.4% annual returns since its inception versus a 0.9% loss for the S&P 500.

The team from Royce Funds likes the space so much, it has  dedicated Royce Low-Priced Stock Fund (RLPHX) and Royce Micro-Cap Trust (NYSE: RMT) to it. A quick dig through Royce filings yields some interesting ideas:

*Roycefunds.com and Capital IQ, a division of Standard & Poor's.

On first glance, these pennies appear to be trading cheaply. While much more in-depth research would need to be done, these types of low-priced opportunities tend to catch our eye.

Special opportunities
Again, we don't like penny stocks simply for their share prices. However, what we do enjoy is that most institutions, Wall Street analysts, and mutual funds either won't or can't dive into these depths of the market. Low-priced stocks are just one of many rich areas where a significant amount of players are simply too greedy or too fearful to profit from.

That's one of the reasons the Motley Fool Special Opportunities team was formed. Led by old school Fool Tom Jacobs, we dig through the rubble to find unique opportunities that the market has quietly left for dead. We search through low-priced stocks as well as bankruptcies, spinoffs, and even discarded large caps that the market either doesn't understand or ignores in plain sight. We use scuttlebutt research, look through cash flow statements, value companies by the sum of their parts, and run a host of proprietary screens to unearth the absolutely best investment candidates.

Membership to this service will be strictly limited, so only request a special invitation below if you're serious about opportunistic value investing, want to compound returns better than the market, and enjoy working with a community that will continually push you to be a better investor. If so, enter your email address in the box below, and I look forward to serving with you.