Who's Afraid of a Penny Stock?

If, like me, you're looking for more than index-like returns, you know that Buffett-esque success depends on navigating the market's ongoing fear-to-greed continuum. Luckily 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 causes you to wet the bed, 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," able to discern share price from the true value of an enterprise, let’s 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 in which the SEC suspended trading 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, they remain 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 thousands of candidates. Digging deeper, hundreds of these companies have market caps greater than $500 million, a majority of which 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.

Penny stocks don't automatically signify bogus companies with flimsy business models. Usually, companies with penny stocks have fallen on hard times -- whether from a burdensome debt load, share dilution, a negative industry trend, or the loss of a major client. The trick lies in separating the underdogs from the dead ducks.

Pitching pennies
Even some of the best hedge-fund mangers in the world occasionally invest in penny stocks. David Einhorn -- an investing legend in the making -- stops to pick up the occasional penny. Recently, he's been a vocal and proud holder of Sprint via Greenlight Capital -- a $7 billion fund with 22% annualized returns (net of fees) since 1996.

Alternately, just look at the team from Royce Funds. They like the space so much that they’ve dedicated two funds, Royce Low-Priced Stock Fund (RLPHX) and Royce Micro-Cap Trust, to this general space. A quick dig through Royce filings yields some interesting ideas:

Source: Roycefunds.com and Yahoo! Finance.

On first glance, these pennies appear to be trading cheaply. While we'd need to do much more in-depth research to confirm that hunch, 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, we do enjoy 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 from which a significant amount of players are simply too greedy or too fearful to profit.

That's one of the reasons we formed the Motley Fool Special Opportunities team. 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, which the market either doesn't understand or ignores in plain sight. We use scuttlebutt research, examine cash flow statements, value companies by the sum of their parts, and run a host of proprietary screens to unearth the absolute 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’ll see you on penny lane.