The beauty of penny stocks

William at A Financial Revolution has some words of advice on penny stocks.

The beauty of penny stocks is that they are one of the only investments for which one simple, blanket rule applies without any exceptions: There is never a good reason to buy a penny stock, ever.

Why not?

Penny Stocks Cost Very Little For a Reason.

The efficient market hypothesis states that the stock price generally reflects all available knowledge about that security. In other words, a $2.00 stock is worth $2.00 to most people — no more, no less.

If there were solid data or a concrete reason for the stock to be valued at a higher price, it would already be at that price. It is incorrect to think that you are getting a bargain when you purchase a penny stock. If you purchase a penny stock, you are gambling — you are not investing.

Penny Stocks Are Not Cheap.

When investing, it is important to know how to value a stock. This concept is the topic of hundreds and hundreds of investment books. It is entirely possible that a stock trading for $72 is cheaper than a stock selling for $8. The price of a stock does not determine whether or not a stock is expensive. There are many other metrics for that.

My favorite (and easiest to understand) metric is the Price Earnings (P/E) ratio. The P/E ratio, roughly speaking, is a ratio which relates the price of the stock to the earnings that one can expect to receive from the share of the stock. This ratio lets you compute how expensive a stock is. The higher the P/E ratio, the more “expensive” a stock is. There are many documented problems with a P/E ratio, but I find that for basic analysis it is a good way to compare the relative value of very similar companies.

When you compare the P/E ratio of penny stocks to solid stocks, you will notice that the P/E ratios for most penny stocks are much higher. This is because penny stocks often have very few earnings, and their value (what little value there is) is derived from expectations of future earning (beyond the scope of the P/E ratio). Because the company has a very low (or negative) P/E ratio, you know that the company isn't making much money yet.

Making a Profit is Not Easy.

Over 95% of businesses fail before the completion of their first year of operations. Investing in a new company with no proven track record is very, very risky. Roughly speaking, if you expect a total loss of your investment 95% of the time, a two-fold increase in your investment 4% of the time, and a ten-fold increase in your investment 1% of the time, the expected value of your $1000 gamble is -$820 ($180 left).


($1000 * 95% * 0) + ($1000 * 4% * 2) + ($1000 * 1% * 10) = $180

Even this scenario is wildly optimistic since the chances of the stock being so successful (10x growth) is much less than 1%. With penny stocks, you're risking failure a most of the time. Sure, you might get a huge return if the company goes big. But I contend that you can get similar returns over time by investing in well-picked, small-mid sized companies with a proven track record of earnings!

Penny Stock Prices Are Easily Manipulated.

Since penny stocks have such low market capitalization (low share price and/or very few outstanding shares), people can easily manipulate their stock price by putting in large buy or sell orders.

A common tactic used by many scam artists is a “pump and dump”. The scamsters buy many shares of the stock at a low price and then pump up the stock. They spam investors (via fax or via e-mail), claiming that they have a “hot new stock.” The stock is artificially hyped by the scamsters who own shares. Even if a only a few people believe the hype, they will purchase enough stock to push up the stock price. As soon as there is a large purchase, the scamsters will sell all their shares, which will send the stock price plummeting. This leaves the scamsters with the profit and the scam-ees with depreciated shares of a useless company.

If You're Going to Gamble, Get Better Odds.

Honestly, if you are looking for a quick way to double your money, my suggestion is to take all the money you'd put into penny stocks, head to the nearest casino, and play a hand of Blackjack with favorable rules. The expected value of your $1000 gamble is close to -$10 as opposed to -$820!

Final Verdict: F-

Thanks, William! For more of his advice, check out A Financial Revolution, which is a personal finance blog “geared toward the younger generation”.

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MoneyMan
MoneyMan
13 years ago

That’s a great point that not many people understand- it is possible for a $2 stock to be wildly expensive, and a $500 stock to be cheap.

I wouldn’t go as far as saying that buying a penny stock is gambling in all cases. In some cases, you might have located an undervalued gem. If you do your research and kick the tires, you might find yourself a great penny stock.

It’s highly unlikely, but it’s not impossible.

Steve
Steve
13 years ago

“Over 95% of businesses fail before the completion of their first year of operations. ”

I’d like to see a source for this.

Joe
Joe
13 years ago

Research is the key, of course. You should never buy something you don’t understand.

Jobu
Jobu
13 years ago

Nice article, I like it.

I think that the 95% statistic is probably true when you take into account all the mega-tiny business that are started up and then abandoned very soon thereafter. I would assume the number is smaller, but still on the order of 60%+ for companies that get listed.

I do like the part about gambling for better odds… Hidden gems are out there, but they’re very difficult to find. I do think it’s a gamble.

Joel
Joel
13 years ago

The poster sez: “The efficient market hypothesis states that the stock price generally reflects all available knowledge about that security. In other words, a $2.00 stock is worth $2.00 to most people – no more, no less.” The thing I’ve heard along these lines is that people who buy stock are generally subscribing to the “greater fool theory” in which they buy in the hopes of selling the stock for more money to a “greater fool”. The wisdom we are to glean from this is that stocks are worth what they cost, period. But, to the stock-buying public, this is… Read more »

Matt
Matt
13 years ago

Devotees of Warren Buffett argue that he and Benjamin Graham have fairly well disproven the “efficient market” theory, and there’s definitely some substance to that. Buffett wouldn’t disagree with the general statement about penny stocks, though.

William Wallets
William Wallets
13 years ago

Hey guys, thanks for all the comments. I wanted to clarify some points, because I definitely agree with a lot of the comments. I actually was just trying to be a bit too clever by making the blanket statement that there is NEVER a reason to buy penny stocks. I should have worded it less strongly. In other words, I think it is very very rare in which there is an instance where one should buy a penny stock. In general, I am a believer in the weak-form of the efficient market hypothesis. In other words, I do think that… Read more »

Anon
Anon
13 years ago

The efficient market hypothesis states that the stock price generally reflects all available knowledge about that security. In other words, a $2.00 stock is worth $2.00 to most people – no more, no less. If there were solid data or a concrete reason for the stock to be valued at a higher price, it would already be at that price. It is incorrect to think that you are getting a bargain when you purchase a penny stock. If you purchase a penny stock, you are gambling – you are not investing. Nothing you’ve said here has depended on the stock… Read more »

Brian
Brian
13 years ago

Indeed a penny stock is a gamble and those that buy them should know that. If you prefer a little immediate gratification during your gamble go to a casino.

If on the other hand you are trying to invest stay away from the .ob’s and get in a solid mutual fund or a blue chip stock.

Mr.Magoo
Mr.Magoo
12 years ago

Well Sheepeople, your intelegence once again shines brightly! LOL. It doesn’t matter what the price is because what are you going to do when the dollar falls flat on it’s face. If any of you had an ounce of smarts you would buy precious metals. Then you can Laugh all the way to the Bank. GET OUT OF STOCKS ALL TOGETHER!!!

Louis Shain
Louis Shain
11 years ago

Very informative blog. I don’t necessarily believe all points though. I know that penny stocks are worthless, in fact, most of them are driven by news and hype and not the company itself. However, in knowing so, I’ve been able to receive returns investing in penny stocks far greater than i could in the NYSE. With penny’s you just have to realize that none of them are investments. You must trade smart, get out and realize your gain as soon as you do, AND NEVER go back to that stock. For instance, this year thus far, I am up about… Read more »

Bryce
Bryce
10 years ago

Oh. Well i guess i shouldnt have invested $50 and turned it into $730. maybe next time ill buy a single share of US STEEL and turn $50 into $60……………….Genius you are William…..

Shawn
Shawn
10 years ago

LOL…I agree with what Bryce said. People are making money in penny stocks. Getting rich too at it. It’s just a lot of people lose money so they talk bad about penny stocks simply because they haven’t got lucky and profited off of them. For one thing penny stocks isn’t like buying Blue Chips or other high priced stocks. There are no rules. You go with your gut instincts…there’s no EPS readings, PE ratios, history of the stock, etc. Throw all that “Brainiac stuff” out the window when it comes to penny stocks. As soon as you realize this you’ll… Read more »

Shawn
Shawn
10 years ago

Who said anything about businesses only lasting no longer than a year?(Reading the article)I’ve seen penny stocks open for years on the historical quote.Some companies lasted like 10 years in business.They actually do shoot up and down during those months or years. No one makes money hardly with the high priced stocks because they move up too slowly and are usually limited in growth because they’ve reached their max most of the time. High risk, High reward. Low risk, low reward. “Wow, I made .26 cents on Microsoft today!” LOL I can buy that Lambroghini I always dreamed of now.… Read more »

henry@penny stocks
10 years ago

Penny Stocks should add up to no more than 10% of your total investment portfolio. Penny Stocks are a very risky investment but if you are diligent, you may become one of a small group of investors who have experienced a tremendous profit. Research thoroughly, invest slowly and carefully and this could fatten your retirement nest egg.

KeNclousezels
KeNclousezels
7 years ago

I’ve been a member TheHotPennyStockPicks penny web site since 2009 and they provide excellent penny stock picks and expert services that I’ve done well with. I am a member of twelve penny stock membership web-sites, but they give each possible useful resource a trader may well need to have.

KeNclousezels
KeNclousezels
7 years ago

I’d like to reveal a penny stock website that I have been utilizing for the past several years. I have to admit they are really truly excellent! They’ve been providing penny stock picks for many years on the net and I absolutely suggest them in case you are buying and selling these kind of stocks. Take a look at their web site: http://www.thehotpennystockpicks.com and look around.

John
John
7 years ago

As an author you will never make money, EVER.

Ken Roberts
Ken Roberts
7 years ago

The advice is simply wrong to apply it to ALL penny stocks. I have had great success with “some” penny stocks. The latest being Fannie Mae which I purchased 50,000 shares and held at 27 cents for 4 years. When the price shot up 1500% in 2 weeks I did not get out exactly at the top but no matter, I made 500% on my investment and am STILL holding a lot of shares. However now I have a large amount of cash in that account. If I had $100,000 I would rather risk $25000 on penny stocks and watch… Read more »

Jamie Aranoff
Jamie Aranoff
7 years ago

This is totally wrong, like any business, penny stocks involve risk and the potential to gain or suffer dear loses. Apparently the author, does sound afraid of jumping into risks. If that be the case, I rather buy penny stocks. True, a $2 stock could be too expensive, but remember not long ago everybody argued that Fannie Mae was a bargain at $33 (Year 2008), and people kept buying because it was too cheap. The same was true of all banks and almost 75% of stocks that declined to staggering lows in 2009. Many were considered fundamentally too expensive and… Read more »

John Douglas
John Douglas
7 years ago

Not all penny stocks are bad investments the key is knowing which ones are about to breakout and which ones are already down and out.

Daniel
Daniel
6 years ago
Reply to  John Douglas

A lot of my money is in penny stocks but in Australian stock market. Gold & oil stocks. The key will always be to buy low and sell high…selling all the way up rather than buying at the top. Time and patience is also key. It takes time to grow a company but backing the right management & resources…staying focussed on fundamentals rather than which way the chart is moving is key. In a good market penny dreadful companies trade a lot higher than in bad markets. Don’t be afraid of a capital raising. Capital raisings exist to assist the… Read more »

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