Introduction
Penny stocks are defined by the U.S. Securities and Exchange Commission as shares of common stock issued by small public companies that trade for less than $5 per share. They are also known as OTC stocks due to the fact that they are priced over-the-counter, rather than on an exchange, for instance on the OTC Bulletin Board.
Since the shares are so cheap, investors can buy large quantities investing relatively small amounts of money, thus making their prices fluctuate wildly. This implies that the market for penny stocks is naturally characterized by an excessive volatility. Since volatility is a measure of risk, penny stocks are considered to be high-risk investments. In addition, penny stock companies are small cap stocks, which by definition implies having a market capitalization less than $2bln.
Other factors contribute to the riskiness of penny stocks such as the fact that generally they are illiquid, i.e. it is very hard to enter and exit positions because very few shares are traded. In addition, we should also consider that many companies that trade as penny stocks are completely new and therefore have no history or track record whatsoever, which represents an obstacle from the point of view of a potential investor. Furthermore, very often they sell products or offer services, which are still work in progress and have to be fully tested on the market.
We all know that, when investing in a stock, it is really important to have a deep knowledge of the company’s business, core activity and financial information. News about large public companies can be easily found on the Internet, including their financial reports which are published periodically on the website of the SEC. In contrast, companies with a very small size, generally those companies that have less than $10mln in assets, are not required to file financial reports to the SEC. This makes it more difficult for investors to find useful information in order to assess whether a given penny stock company has solid financial fundamentals or not. As a consequence, investors are exposed to a higher risk of investing in companies that later turn out to be worthless, or even fall into investment fraud schemes.
Pump and dump scheme
As mentioned before, nowadays investors should be careful to avoid penny stock frauds, such as the “pump and dump” scheme. This fraud consists in buying a penny stock, artificially inflating its price by spreading false positive information about the company and then selling those overvalued shares at a higher price. Once the shares are sold their price will significantly fall, leaving the scammed investors with huge losses.
Without a doubt the diffusion and expansion of the internet has made this kind of security frauds easier to perform, allowing scammers to reach and mislead potential investors through mails or even on social networks.
Figure 1 Graphical representation of Pump and Dump scheme; Souelaboration of the author
In spite of all the aforementioned risks penny stocks surely represent an interesting opportunity to make a potentially large profit by investing relatively little capital. Being aware of the risks and scams related to the penny stock market, if you see some potential in a penny stock company firstly you should try to gather as much information as possible about it. Only then, if you are able to really understand whether the company has some real potential to grow, you should go through with the investment.
Two notable “penny stocks”: Monster and Ford
In fact, there are various instances of companies that initially started out trading as penny stocks and eventually ended up being large, well-known corporations. One such example is Monster Beverage Corporation which started out trading as a penny stock for under $1 in 2003 and eventually became a popular and renowned company in the energy drink industry. Nowadays, its shares are trading just above $74 dollars, which means that they have increased in value by approximately 70.000% since their public debut in 2003, outperforming every other stock in the US in the last 20 years.
Figure 2 Monster Beverage Corporation stock price movements; source: Yahoo Finance
However, sometimes even well-established companies might end up trading as penny stocks during particular times. This is what happened to Ford Motor Company, which became a penny stock (trading under $2 per share) during the 2008 crisis, around the time its main competitor, General Motors, went bankrupt. Approximately one year later, the stock recovered settling around $15 per share. This means that those investors who bought the stock while it was trading as penny stock and sold it one year later earned a return, assuming no transaction costs for simplicity, of 650% per share in just one year.
Figure 3 Ford Motor Company stock price movements 2007-2016; source: Yahoo Finance
Conclusion
To sum up, it is indeed possible to make large gains by picking those penny stocks that have the potential to become strong, well-established companies, even though it is easier said than done. In fact, when an investor chooses to put money into penny stocks, he should always take into account the high volatility and high risk implied by the penny stock market, which could make him lose all the funds he has invested in the blink of an eye. In addition, as I mentioned earlier in the article, investors should look out for scammers trying to rob them through schemes such as the “pump and dump”.
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Disclaimer
The ideas and opinions expressed in this report are the ones of the author and do not reflect in any way the ideas and opinions of Bocconi University. This report is intended for academic purposes only and is not intended to be an investment advice and thus should not be interpreted as such. Reliance of the information contained in this paper is at the sole discretion and risk of the reader.
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