Penny stocks, often the target of securities investigations, continue to lure the unsuspecting investor by offering the unstated promise that a stock this cheap can only go in one direction, up. Don’t believe it. Investors looking for that “next big thing” are often lured into the Pennystock market only to learn the Googles, Microsofts and Apples of the world didn’t start as penny stocks.

One reason penny stocks are under the microscope of the Securities and Exchange Commission (SEC) is because there is often a lack of legitimate information which makes them easy targets for fraud. There have been cases of some penny stock companies paying people to recommend them in the media, including financial television and in newsletters.

I get spam e-mails all the time trying to get me to put money into a particular stock that’s allegedly on the verge of taking off. There will language like “Could this be the next GE, or Microsoft?”

Earlier this month, the SEC charged Gendarme Capital Corporation and two executives with violating securities-law registration requirements in an alleged illegal stock distribution involving penny stocks that netted profits of more than $1.6 million.

For those of you who aren’t even sure what a penny stock is, it’s not a stock that sells for a penny, although some are probably worth less than a penny. Penny stocks are what are known as micro-cap stocks in that they have a relatively low market capitalization, generally between $50 and $300 million, or nano-cap stocks which are those companies with than $50 million. They often trade for less than one dollar a share and on the Pink Sheets or the OTCBB (Over the counter market). Others say defining the amount is any stock under $3.

Under $5

It’s interesting that the SEC considers any stock under $5 as a penny stock, but no one else does. Following the SEC standard, Citigroup would be a penny stock, as would have Ford when it hit its bottom. So for this article, we’ll stick with the under a dollar rule.  

The key thing for investors to know is that penny stocks are much riskier than regular stocks, for a number of reasons:

  • Lack of information real information since they are not required to file with the SEC and a good deal of the information available is just as likely to come from a less than credible source.
  • There are no minimum standards, which is why these stocks are no longer listed on one of the major exchanges.
  • A lack of history because they are either newly formed or approaching bankruptcy which means they will have a poor track record or none at all.
  • They lack liquidity which means there’s a good chance the stock you purchased can’t be sold or its price is easily manipulated.

Then you have all those off-shore brokers who buy the penny stocks at a discount and then they’re sold back to U.S. investors at profit, without having to register anything with the SEC.

Biggest lie

The biggest lie being perpetrated about penny stocks is that many of today's successful stocks were once penny stocks. That is simply untrue.  In fact, most of these stocks do not succeed, and there is a very high likelihood that you will lose your entire investment if you put money into them.

Does that mean all companies that are trading at their all-time lows won’t recover?  Of course not. And several companies trading on Pink Sheets and over the counter are good quality companies that may one day qualify for either Nasdaq or the NYSE. You just need to know those companies are in the minority and that you know what you’re getting into before investing in a company whether it’s a penny stock, small cap,mid cap or large cap. They all have the ability to rise, fall or stay the same no matter where they are today.