Why We Love Wild Penny Stocks

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

The potential rewards are enormous. In fact, pennies have been the best performers lately. Let's take a look at the five biggest gainers of the past month, among all stocks traded on major U.S. exchanges:

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

These five stocks have been on a tear lately, and all are true penny stocks -- sub-$5.00 share price, sub-$100 million market cap. Their one-month triples look like easy gains when stacked up against a popular stock like Google, which would trade for nearly $1,800 per share if it were to triple from current prices. (We'll tell you later why we're not convinced that they'll sustain these run-ups.)

Everybody loves pennies
The potential of quick gains in "cheap" stocks keeps investors coming back. We recently typed "penny stocks" into Google, and the search engine spat out more than 1.8 million hits. We did the same for more time-tested terms such as "blue-chip stocks" and "dividend stocks," and got just 189,000 and 271,000 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 Tampa, Miami, and Orlando -- the locales where the term is most often searched.

We hope the folks Googling "penny stocks" down there aren't retirees trying to cope with this crazy market.

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 Level 3 Communications (Nasdaq: LVLT) as a penny stock -- Level 3 is a $2.5 billion company, even though it trades for $1.55 a share, and doesn't have much of anything in common with a penny stock. (In fact, Level 3 is given good marks -- four out of five stars -- by our Motley Fool CAPS community of investors.)

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?
Nonetheless, 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, 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
Though we don't believe the five companies listed at the top of this article will continue their torrid outperformance -- none of the five have turned a profit in the past year, and they operate in intensely regulated and competitive spaces (biotech, real estate, and regional banks) -- they are traded on a major exchange, so they're not quite the stuff of black-box OTC stocks. But in either case, if you're buying stocks without paying attention to the underlying businesses, 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 Class 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 -- though you're probably not saying that any longer -- let us introduce you to some underfollowed, value-priced small caps. They're nothing like penny stocks, yet they still offer some of the best returns on the market. Unlike penny stocks, the right kind of small-cap value stock will have:

• A history of top-line and bottom-line growth.
• Manageable or no debt.
• A founder/CEO or strong ownership culture among management.
• Little or no coverage from Wall Street analysts.
• Rising demand for its products or services.

That's a starting point for some of the things to look for in a great small-cap company. Our team at Motley Fool Hidden Gems also likes to see high and rising rates of return on equity and low multiples relative to its growth rates.

In other words, we're looking for big returns with good old-fashioned bottom-up analysis.

You can view all the small caps our team likes now 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 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 ... but the Treasury is probably busy with other issues right now. Neither owns shares of any company mentioned. Google is a Motley Fool Rule Breakers recommendation. The Fool's disclosure policy is finger-lickin' good.