Is There Such a Thing as a Good Penny Stock?

Penny Stocks Offer More Risks Than Rewards, but There Are Paths to Profit

It’s a funny thing about penny stocks—people will invest in them even though they suspect the share price is being manipulated, according to a recent study by the National Bureau of Economic Research.

What’s the attraction? By definition, penny stocks, also called micro-caps, don’t cost a lot (under $5 per share), and investors are attracted to the notion of turning $1 into $2 and getting 100 percent (or more) return on the dollar.

After all, it’s easier to double your money on a $1 stock than a $10 stock, right?

But that’s really not the case in most penny stock trading experiences. The odds are actually higher you’ll lose more money than gain from a penny stock investment.

First, a few facts on penny stocks, and then a quick dive into whether investors can actually find good “profit potential” penny stocks:

  • Penny stocks are usually on an over-the-counter basis, on either the OTC Bulletin Board or on OTC Link, and, less often, on NASDAQ and the American Stock Exchange.
  • Penny stocks can trade on other securities exchanges, most notably in foreign stock markets.
  • Penny stocks usually are tied to younger companies, with low cash reserves and little or no track record.
  • Penny stocks can also be defined as the securities owned by private firms, blocked off from public trading.
  • Penny stocks don’t usually trade frequently, making them less liquid for owners.
  • Penny stocks are highly speculative, and are often hard to price accurately.
  • The U.S. Securities and Exchange Commission has strict rules on penny stock trading, including written documentation from broker-dealers on the higher relative risk of investing in penny stocks.

Give the high-risk and low liquidity of penny stocks, can investors actually uncover some winners in the sector?

The answer is a shaky “yes”, and only if you follow the following guidelines:

  • Focus on Earnings: Target penny stocks that have robust earnings growth and that trade close to its 52-week high.
  • Don’t Trust Penny Stock Newsletters: Often, penny stock investors turn to penny stock newsletters for good recommendations. Yet, just as often, those newsletters are unreliable and actually own shares in the same penny stocks they’re touting. If you do check out penny stock newsletters, make sure you read the disclose notice included inside (a mandatory inclusion by the SEC). The disclosure notice can provide any conflicts of interest by the newsletter provider.
  • Aim for Penny Stocks With Heavier Trading Volume: The more a penny socks trades, the more reliable it is. That’s why it’s important to focus on penny stocks that offer a high trading volume (aim for penny stocks that trade over 100,000 shares per trading session.)
  • Abide By the “Over .50 Cents Per Share” Rule: Another good rule of thumb—only trade in penny stocks with a price over .50 cents per share. Stocks that trade for less than that price are usually highly speculative, and include companies with no discernable track record of success.
  • Only Buy Penny Stocks of Companies That Make Money: This may see obvious, but with penny stocks, leave no stone unturned in your research. Consequently, check the company’s financials before buying a penny stock. If there’s documented proof that the company makes a profit, the odds are lower of losing money on a penny stock purchase.
  • Don’t Buy a Penny Stock That’s “Talked Up”: The penny stock market is littered with the broken dreams, and drained bank accounts, of investors who purchased the stock based on an “expert’s” opinion that the stock price will eventually skyrocket. Penny stocks are notorious for having existing shareholders, who often present themselves as objective investing experts tout” or “talk up” the stock to artificially inflate its price. Don’t fall for that scam. Stick to the company’s financial statements and its record making money and paying its bills. Those are the key indicators that a penny stock may offer financial opportunity for investors.
  • Be Patient: Once you identify a penny stock that offers potential gains, don’t buy it right away. Instead, track the stock for a week or so and monitor how it trades, especially targeting frequency of trades (trade volume), volatile share price swings, and knowing the best “entry price” before pulling the trigger on a purchase.
  • Be Practical: With penny stocks, the odds of losing 25 percent or more of your investment are stronger than earning that rate of return. Consequently, if your penny stock investment ticks significantly upward, count your blessings and sell on the upside—it’s likely your best chance of making a profit on penny stocks.

Overall, know that the odds of finding a good, solid penny stock that reward you with profitable gains are against you. That said, finding a diamond in the rough isn’t impossible if you stick to the tips and tenets listed above—and on a regular basis.

Otherwise, don’t bother with penny stocks, unless you have money to burn.