Penny stocks have huge potential -- that's their blessing and their curse.

The potential rewards are enormous. Just take a look at the returns from Hudson Technologies (Nasdaq: HDSN) and Star Scientific (Nasdaq: STSI), which have each more than doubled since the beginning of the year. Neither traded for more than $1.00 per share when 2008 started.

Those $1 doubles look like easy gains, considering that U.S. Steel (NYSE: X) would have to add another $175 in value to double its share price, and Potash Corp. (NYSE: POT) would need to throw another $203 on the fire to eke out another double.

Everybody loves pennies
It's the potential of quick gains in "cheap" stocks that keeps investors coming back. We typed "penny stocks" into Google, and the search engine spat out "about 2,910,000" hits. We did the same for more time-tested terms such as "blue-chip stocks" and "dividend-paying stocks" and got just 421,000 and 764,000 hits, respectively.

Sure, we expected a discrepancy, but the size of the gap was startling. It became even more interesting when we broke down those hits with Google Trends. According to Trends, penny stocks are particularly alluring to investors in Las Vegas, Tampa, and Orlando -- the locales where the term is most often searched.

Las Vegas, for one, makes a bit of sense. Those folks are gamblers.

Florida, though? Well, we hope the folks Googling "penny stocks" down there aren't retirees.

This stock is set to take off! Or not
According to the Securities and Exchange Commission, the term "penny stock" generally refers to low-priced (below $5), speculative securities of very small companies. To quote the SEC: "Investors in penny stocks should be prepared for the possibility that they may lose their whole investment." (It's worth noting that the emphasis in that last sentence is in the original.)

Pay attention to the SEC's entire definition, not just the stock price. Going solely on price would wrongly categorize billion-dollar companies such as JetBlue (Nasdaq: JBLU), Unisys (NYSE: UIS), and Ambac (NYSE: ABK) as penny stocks.

Regardless, the SEC is spot-on when it says that true penny stocks are among the surest ways to lose money in the stock market.

Well, then, why do we love penny stocks?
We love penny stocks because they're fascinating. The world of pennies is inhabited by hardworking average Joes hoping to strike it rich, as well as by pumpers and dumpers, hypesters and scammers. In pennies, the logic and reason that applies in the rest of daily life is replaced by zeal and prayer.

However, we don't love them enough to actually buy them. Yes, they have big potential, but their daily gyrations are unpredictable -- the stock price movements have next to nothing to do with the underlying company the stock represents. In fact, trading in pennies is highly illiquid, and prices are often manipulated by forces not at all related to the business.

The dangers of incredible promises
If you're buying stocks without paying attention to the business you're buying, then you might as well be buying a lottery ticket. Or, to use another analogy, you might as well buy up every baseball card of a benchwarmer on the Akron Aeros AA baseball team and hope that he someday rises up, fulfills his potential, and becomes an all-star for the big-league Cleveland Indians.

There's a better way
Before you start saying the rest of the stock market is boring -- with big stocks such as IBM having a "big day" when they move up 1% or so -- let us introduce you to some underfollowed small caps. They're nothing like penny stocks, yet they still offer some of the best returns on the market. Unlike penny stocks, promising small caps:

  • File reliable financial statements.
  • Are transparent.
  • Have conference calls that individual investors can listen to.
  • Don't simply hype their stock in press releases.

That's a starting point. There are more -- and more important -- criteria to help you find great small-cap companies. Our team at Motley Fool Hidden Gems, for instance, looks for a balance sheet with lots of cash and no debt, and a tenured CEO (or founder, if possible) who holds a substantial ownership stake in the business. In other words, we're looking for big returns with good old-fashioned bottom-up analysis.

You can view the more than 50 small caps our team has already found with a free 30-day trial. There's no obligation to subscribe, and we particularly recommend it for the penny-stock-o-philes reading in Vegas and Florida. You know who you are.

This article was originally published July 27, 2006. It has been updated.

Tim Hanson and Brian Richards disagree about whether the U.S. Treasury should do away with the penny. Neither owns shares of any company mentioned. The Fool's disclosure policy is finger-lickin' good.