We'd all love to get rich quick, right?
Unfortunately, it's not a very easy goal to attain -- though you'll occasionally run across come-ons from the penny stock world that would suggest otherwise. But no less an authority than the Securities and Exchange Commission (SEC) has warned: "Investors in penny stock should be prepared for the possibility that they may lose their whole investment."
Here's a look at what penny stocks are -- and why you should avoid them like the plague. And as a bonus, there's a quick look at how you can get rich, albeit in a more reasonable timeframe.
What are penny stocks?
Penny stocks are generally companies whose stock trades for less than about $5 per share. If you run across an intriguing stock and its shares are only $2.14 apiece -- or, better still, only $0.27 each -- you're looking at a penny stock. The threshold used to be less than $1 a share, but the SEC in recent years has raised it.
Before getting into why these stocks are dangerous, let's look at why they're appealing. It all boils down to math and psychology, really: If you have, say, $1,000 to invest, you can spend it on about 15 shares of a $67 stock -- or you might instead buy more than 2,100 shares of a stock trading at $0.47 per stub. If you think the latter scenario is more appealing, you've got plenty of company -- but you're also mistaken. Many people find it more exciting to own 2,100 shares than 15 shares, and it can make some folks feel richer, too.
But a stock's share price doesn't really tell you too much (other than if it's around $5 or below and is, therefore, a penny stock). A stock trading for $800 per share can be undervalued and on its way to doubling in a few years, while a stock trading for just $18 per share might be overvalued and due for a drop.
Consider the stock of Amazon.com, recently trading around $2,100 per share. That seems "too high," right? Like it couldn't go any higher and couldn't be a bargain? Well, consider that only a year ago its shares were trading around $1,640 apiece, another lofty price that probably seemed too high to many people. Over that single year, the stock gained 28%. There's a good chance that in five years, Amazon's shares will be far higher (or will have split), while many companies with shares trading for less than $5 will be out of business or failing.
You can get more meaning from stock prices by relating them to other numbers. For example, multiply a stock price by the company's total shares outstanding, and you'll arrive at its market capitalization -- its current value in the market. Take game and toymaker Hasbro: It was recently trading for $90 per share and had nearly 137 million shares outstanding. Multiply those numbers and you arrive at a market cap of around $12.3 billion, making it a "large-cap" company. Many penny stocks not only have tiny share prices, but they also have relatively few shares outstanding, making the entire company not worth very much.
So a typical penny stock will have an ultra-low stock price and very often a low overall value as a company, too. Yet it will probably have come to your attention because someone is hawking it online or hyping it in a newsletter. These folks will likely be trying to drum up interest and buyers and will be getting your hopes up, suggesting (or even nearly guaranteeing) that the company is about to discover gold, strike oil, or cure cancer. They'll suggest that you can get in on the ground floor right now, and make huge profits, soon.
What I've just described is the "pumping" part of the age-old "pump-and-dump" scheme. Penny stocks, which can be easily manipulated due to their low share counts, are played up so that naïve investors snap up shares. All that buying activity drives up the price, making those investors happy -- briefly. But the hypesters bought their own shares earlier and have also benefited from the stock price surge -- and now they will sell their shares, "dumping" them and sending the shares crashing.
Penny stocks are used in classic pump-and-dump schemes, with investors excited about how the companies might soon prosper. But take a close look at the companies and you'll learn that there's often very little there there. Try to find the company's website, and if you do, see how professional it looks. Maybe compare it to other companies' sites, such as those of, say, Clorox, Kellogg, or Waste Management. See what information it offers about itself and what it offers to investors. Are there links to many quarters' and years' worth of financial statements (such as 10-Qs and 10-Ks) filed with the SEC? If you find financial statements, do they show ample cash and little to no debt? Are revenue and earnings at that company rising? Some companies behind penny stocks may eventually succeed and grow, but many are small and running on fumes, carrying a lot of debt and lacking the resources to pull off their strategy. You need to do due diligence before investing in any stocks, but especially penny stocks.
A better way to build wealth
Buying into penny stocks isn't investing -- it's speculating, or gambling. It's very risky and should be avoided at all costs. So how can you build wealth? Try a different kind of stock -- the promising kind. Look for established companies with many years of financial statements filed, showing generally growing revenue and earnings. Profit margins growing is also a good sign. Look for companies with little to no debt and ample cash on hand. Look for smart management and clear communications from management, such as via a candid and informative annual letter to shareholders. Favoring dividend payers is also a good move.
And if that sounds like too much work, just opt for a simple low-fee, broad-market index fund, such as one that tracks the S&P 500. Invest money in it regularly, and over many years, you should get wealthier.
But whatever you do, avoid penny stocks -- and other money-losing propositions.