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 Syntroleum (NASDAQ:SYNM) and Enterra Energy Trust (NYSE:ENT), which have each more than doubled since the beginning of the year. Neither traded for more than $1.30 per share when 2008 started.

Those $1 doubles look like easy gains, considering that (NASDAQ:BIDU) would have to add another $320 in value to double its share price, and Google (NASDAQ:GOOG) would need to throw another $575 on the fire to eke out another double.

Everybody loves pennies
The potential of quick gains in "cheap" stocks keeps investors coming back. We typed "penny stocks" into Google, and the search engine spat out about 2,380,000 hits. We did the same for more time-tested terms such as "blue-chip stocks" and "dividend-paying stocks" and got just 513,000 and 1,070,000 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." (The emphasis in that 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 that trade for around $5 -- such as Tellabs (NASDAQ:TLAB), National City (NYSE:NCC), and MBIA (NYSE:MBI) -- 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 and Janes hoping to strike it rich, along with pumpers and dumpers, hypesters and scammers. In pennies, 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 entirely unrelated to the business.

The dangers of incredible promises
If you buy stocks without paying attention to the business you're buying, 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, then 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 say that 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
  • Hold conference calls individual investors can listen in on
  • 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. Baidu is a Rule Breakers recommendation. The Fool's disclosure policy is finger-lickin' good.