6 Penny Stock Myths

In penny stocks there are six myths, and some surprising realities

Myths in penny stocks
Man reading newspaper stock market pages. Getty Images

More myths surround penny stocks than any other type of investment vehicle. Of course, there are misconceptions surrounding options, real estate, precious metals, and large stocks, but those which involve the tiniest shares are the most significant. Usually, like all myths, they are way off the mark.

Here are 6 common misconceptions which may surprise you and maybe even give you a whole new perspective.

Better yet, understanding the concepts behind these myths may prove profitable.

Myth:  Penny Stocks are Difficult to Buy and Sell

This may be true for investments trading OTC, OTCQX, or on the Pink Sheets. However, there are plenty of penny stocks on the Bulletin Board, NASDAQ, American Stock Exchange, and New York Stock Exchange. Since there is so much more interest and trading activity among these larger markets, the penny stocks listed on them are very easy to buy and sell.

There are plenty of penny stocks which trade hundreds of thousands of shares each day, and they are as easily bought and sold as the major blue-chip companies. Even on the lower-profile exchanges, there will usually be enough interest that an investor is able to buy and sell as required.

Myth:  Microsoft was Once a Penny Stock

Microsoft (MSFT) made its trading debut in 1986, at $21 per share. By the end of the day, shares settled at $27.75, and the stock never looked back.

So why is the prevalent belief that Microsoft was once a penny stock? Actually, it comes down to a misunderstanding of how trading charts display share splits.  

A quick refresher on share splits: Consider a 3-for-1 split (properly displayed as 3:1) of a $99 stock. Each share you own gets replaced by three shares worth $33 each.

A long term trading chart will then display all previous prices at one third the price at which they were actually previously trading.

If you split a share 2:1, then again 2:1 years later, then 3:1 a decade later, the long term investor now has 12 shares for their original one. Using this example, a stock which was originally $1 will display on the trading chart as having been priced at the very beginning as an 8 cent stock (one twelfth of a dollar).  

When shares of MSFT split 2:1 in September, 1971, this doubled the number of outstanding shares, while halving the price of each on the trading chart. This was followed by nine more splits over the years.  Each split dropped the relative trading prices displayed on the chart further, as the effect of the split was taken into account.  

While an all-time chart of MSFT will show the current price of a share, which is around $50 depending when you are reading this, it will also display the split-adjusted price of 9 cents, on March 1st, 1986.  This is despite the fact that MSFT was worth $21 at that time.

Myth: The Shares are Listed on the Stock Market, So the Company Must be Legitimate

This is a myth which is near and dear to my heart, because it is one of the reasons I was financially wiped out within two weeks (when I got started, at 14 years old).

 I equated a company's stock market listing with legitimacy. Unfortunately, there are plenty of shares trading on the stock market, which are broken or collapsing companies and may cost people every penny they invest.

Companies are able to maintain a stock market listing long beyond the point of closing down operations, going bankrupt, or being investigated by the authorities. Sometimes, businesses just quietly die off or fade away, while their shares keep being bought and sold.  

The exchanges require certain paperwork for a stock to voluntarily delist their shares, yet there might not be any employees at the company, or anyone who will bother following the appropriate bureaucratic channels.

Myth: The Shares Can't Go Much Lower

At 85 cents, shares which were once trading at $4 may look like a bargain on a trading chart.

However, investors probably aren't getting a deal.

The statement by newer investors is usually, "How much more could it really fall?" They may cite the fact that the shares used to be closer to $4, almost as an argument as to why the stock will probably increase in price.

Well, the answer to how low it might it go... is all the way to zero. You can lose 100% of whatever money you invest, whether you put that into the shares at $4, $2, or 33 cents. Of course, any recovery in the share price will be based on numerous factors, and any penny stock has the capability to rebound. Just never look at how a penny stock was previously valued, because it is meaningless.

Think of the parable about the quarter. If you flipped the coin 9 times, and it came up heads every time, what is the percentage chance of the next toss coming up tails?  The answer is 50% - a coin has no memory.

Myth: This Company Will Change the World / Save Lives / Make Millions

The attractiveness of the underlying story is directly inverse to the quality of the investment. What this means is that the most interesting, greed-inducing, incredible stories are usually those which are over-priced, terrible investments.

Developing a cure for a common disease - great. Some penny stock talking about how they are working on a cure for that common disease - almost always a very poorly performing investment.

Money is attracted to simple stories which sound enticing to investors; looking for diamonds; technology which makes salt-water drinkable; cars which run on gravity; breakthroughs in such-and-such disease.  

Unfortunately, every one of these examples was a real company touting their world-changing business.  I'll let you guess what they are worth now, but if you are thinking more than zero, you're expectations are way too high. 

Little-known, tiny companies are forced to have a tremendous story to attract any interest or investment dollars.  One business out of hundreds has an idea which pans out, but the rest of the time these intriguing stocks leave a trail of vanishing dollars and depressed investors.

Myth: Penny Stocks are a Scam / Low-Quality Companies

It is true that scam artists and dishonest promoters gravitate to the lowest-priced investments.  At the same time, the worst quality companies with the fewest prospects often drop into penny stock territory.  However, there are many wonderful, high-quality companies whose shares trade for pennies simply because they are overlooked, misunderstood, undiscovered, or operating in an industry which has fallen out of favor.

The first step is to avoid the pitfalls, and that is simple.  The second step is to find these up-and-coming companies, which are legitimate, led by excellent management teams, and are enjoying soaring revenue growth.  When you invest in one of these, you will no longer consider all penny stocks to be low-quality.

The Final Warning

The Securities and Exchange Commission (S.E.C.) does a wonderful job of protecting investors, considering the limited funds they have to work with, and the sheer numbers of willing scam artists. At the end of the day, most of the individuals using low-priced shares to rip people off are caught and prosecuted.  

Unfortunately for investors, any justice is years later. For smaller investors recovered funds are very low, if not zero. 

Ideally, dis-spelling these common myths will provide a new perspective. Perhaps they help you understand penny stocks better, maybe you avoid some of the potential pitfalls. Possibly you even find some high-quality, low-priced investments which will not be trading for less than $5 much longer.