Is There Such a Thing as a Good Penny Stock?

penny on financial charts
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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:

  • More penny stocks are traded on an over-the-counter basis (approximately 12,000) than are traded on major exchanges such as the NYSE, 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.

Follow These Guidelines to Pick a Winning Penny Stock

Give the high-risk and potential 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 Promotional Penny Stock Advertising: Often, penny stock investors find out about a penny stock from a promotional penny stock advertisement fashioned to look like an advisory newsletter. Often, these publications are strictly promotional in nature and are not reputable advisory newsletters that follow an ethical practice of sound analysis and accurate information delivery. Such promotional materials may be unreliable and can be promoted by people or organizations who actually own shares in the same penny stocks they’re touting. If you are reviewing a penny stock newsletter or similar publication, make sure you read the disclosure notice it should include. (This is a mandatory inclusion by the SEC). The disclosure notice should provide any conflicts of interest by the publisher of the information. If no information is mentioned about whether the publisher or author of the notice holds shares themselves, it is wise to ignore that e-mail or publication.
  • Aim for Penny Stocks With Heavier Trading Volume: The more a penny stock 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 seem 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 to "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 rewards 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.