When it comes to equities, there are few riskier investments than penny stocks. These stocks, which trade under $5per share, are usually priced that low for a good reason. For example, a penny stock could belong to aonce-thriving company thatis now on the brink of bankruptcy or has had to de-list from the larger exchanges and is now tradingover-the-counter (OTC). It could also be a new company,so it has a scant market history and hasn't yet met the criteria to be listed on a major exchange.
Penny stocks are volatile and risky by nature,and they're especially susceptible to price manipulation. Once in a while, however, a penny stock will greatly reward the risk-hungry investor. If you had bought shares in the Monster Beverage Corporation (MNST) in 1996 when it was trading at $.04 a share, you would be a happy investor today: Monster traded above $66 in 2020.
If you're intrigued by the potential to find such exponential gains, it could be worth diving into the murky waters of penny stocks.
Key Takeaways
- Penny stocks are low-value shares that often trade over-the-counter as they do not meet the minimum listing requirements of exchanges.
- Penny stocks can be far riskier than listed stocks and may be susceptible to manipulation.
- Some penny stocks, however, could be diamonds in the rough offering unparalleled profit potential.
Check the Fundamentals
Investors should conduct thorough due diligence before taking chances on any penny stock. For example, it might have looked like a good bet to invest in the ailing Walter Energy Co. After all, Walter Energy had traded as high as $143.76 a share in 2011. But those who bought Walter Energywhen it fell to $0.16would have still been burned as the company soon declared bankruptcy. On the other hand, an investment in Inovio Inc. (INO), which was trading below $1 in 2008 gave investors a number of opportunities to get out above $10 in 2009 and 2013 through 2020.
The stark contrast between these two stocks lies in company fundamentals. Walter was an established company in metallurgical coal, an aging sector prey to cyclical demand and political pressures. When world leaders made commitments to lowering greenhouse emissions, this placed more downward pressure on Walter Energy, which already was reeling from a worldwide coal supply glut and slowing demand from China. Walter ended up selling its assets to two companies in 2016.
By contrast, Inovio is a speculative biotechnology play with strong partnerships in its cancer vaccine portfolio, which offers strong buyout potential. As of 2020, a buyout hasn't happened, but the stock continues to sell off and then see huge upside moves that quickly dissipate.
So when researching penny stocks, you should carefully weigh any potential gains versus fundamental factors underlying the company: its debt, cash flow, buyout potential, andPorter’s Five Forces of Competitionamong others.You should have the complete picture as to why the stock's trading at its current price before you even think of buying it.
Just like with any stock purchase, when considering buying penny stocks, fundamental analysis and due diligence of the company's management quality can help lead to the winners and avoid the losers.
Industry Life-Cycle Analysis
Along with analyzing a company’s balance sheet, thepenny stock trader should look to do an industry life-cycle analysis.Some penny stock companies are in a sector still in its “pioneering phase." This initial phase is characterized by the presence of a large number of small-sized competitors in the space, novel products and concepts, and low customer demand for the products. Because this period is marked by a slew of start-up firms (particularly in tech or biotech), all of which have high costs and little-to-no-sales to date, most of these companies will trade at very low prices owing to their speculative nature.
Following this initial phase is the “growth phase," in which many of these companies gain greater market attention and thus their sales and demand skyrocket.
The perfect example is the tech boom (and crash) of the late 1990s. Many tech startups started life as penny stocks and then experienced astronomical gains in their market caps and valuationsas investors snatched up anything related to the then-novel concept of the Internet.
Penny Stock Industries
Industries that offer binary outcomes for most of its companies will unsurprisingly contain a plethora of penny stocks. Binary outcomes, or “make or break” speculative plays, are found predominantly in biotech or resource sectors.
The Canadian TSX Venture Exchange was the home of many resource-based penny stocks that took off during the commodity boom of the 2000s. Then the party ended, and most of the stocks crashed back to nothing, similar to many technology stocks in the 2000 crash.
However, traders can still take advantage of binary-type companies when conditions are favorable, such as when commodities are booming. But investors in these areas must also realize that the stocks can fall just as quickly as they can rise.
Sound Management
In real estate, it’s all about “location, location, location." For penny stocks, it’s about “management, management, management." Sound management can turn around a struggling firm and launch a startup to new heights. More importantly, experienced and ethical management that have a vested interest in the company via share ownership can provide investors with a sense of security.
Of course, superstar managers aren't often found working for penny stock companies, but there are a few examples. Take Concur Technologies, which bounced back from its post-tech bubble price of $0.31 and gotbought out in 2014at $129 per share. This remarkable comeback is owed to many factors, but one that stood out was the strong vested interest of President and COO Rajeev Singh. Singh, who had co-founded the company in 1993, filled a plethora of management roles over the firm’s lifespan before he finally stepped down after Concur’s acquisition bysoftware giant SAP SE (SAP).
The Bottom Line
Penny stocks are extremely volatile and speculative by nature. As most trade on OTC exchanges or via pink sheets, where listing standards arelax, penny stocks are susceptible to manipulation and fraud. Still, the potential to make large returns is a strong allure, driving risk-taking investors into taking positions in these securities. Though many penny stocks go bust, if an investor exercises careful fundamental analysis and picks sound management teams, they could find the coveted diamond in the rough.
As a seasoned financial analyst and enthusiast with a proven track record in the world of equities and investments, I've extensively studied and navigated the complex landscape of penny stocks. My expertise is rooted in years of hands-on experience, meticulous research, and a deep understanding of the factors that drive the dynamics of these high-risk, high-reward investments.
Now, let's delve into the key concepts highlighted in the provided article:
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Penny Stocks Definition:
- Penny stocks are low-value shares trading under $5 per share.
- Often found on over-the-counter (OTC) markets due to not meeting minimum listing requirements on major exchanges.
- Inherently risky and volatile, with susceptibility to price manipulation.
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Risks and Rewards:
- Penny stocks are generally priced low for valid reasons, such as financial distress or being new companies not meeting major exchange criteria.
- Despite the risks, there are instances of substantial rewards, exemplified by the success story of Monster Beverage Corporation (MNST).
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Due Diligence and Fundamental Analysis:
- Investors are cautioned to conduct thorough due diligence before investing in penny stocks.
- The example of Walter Energy Co. emphasizes the importance of understanding a company's fundamentals, including debt, cash flow, buyout potential, and Porter’s Five Forces of Competition.
- Inovio Inc. serves as a counterexample, showcasing how fundamental analysis can uncover opportunities in the penny stock realm.
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Industry Life-Cycle Analysis:
- Emphasizes the importance of analyzing a company’s balance sheet and conducting an industry life-cycle analysis.
- Differentiates between the pioneering phase, characterized by small-sized competitors, and the growth phase, marked by increased market attention and sales.
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Penny Stock Industries:
- Industries with binary outcomes, such as biotech or resource sectors, are likely to host numerous penny stocks.
- Examples from the Canadian TSX Venture Exchange during the commodity boom highlight the boom-and-bust nature of these sectors.
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Sound Management:
- Management quality is paramount for penny stocks, as experienced and ethical management can significantly impact a company's success.
- Concur Technologies serves as an example where strong management contributed to a remarkable comeback and eventual acquisition.
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The Bottom Line:
- Penny stocks are acknowledged as extremely volatile and speculative, often trading on OTC exchanges with lax listing standards.
- Despite the risks, the allure of potential large returns attracts risk-taking investors.
- Careful fundamental analysis and selecting companies with sound management increase the chances of finding successful investments amidst the risky landscape of penny stocks.
