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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There are 22 comments to "The beauty of penny stocks".

  1. MoneyMan says 27 December 2006 at 13:42

    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.

  2. Steve says 27 December 2006 at 18:38

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

    I’d like to see a source for this.

  3. Joe says 27 December 2006 at 18:40

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

  4. Jobu says 27 December 2006 at 19:50

    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.

  5. Joel says 28 December 2006 at 09:36

    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 manifestly untrue. Why else would we invest in anything if not to hope one day to sell it to a greater fool?

  6. Matt says 28 December 2006 at 12:45

    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.

  7. William Wallets says 28 December 2006 at 13:16

    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 fundamental analysis (Buffet and Graham) can beat the market, but some keen insight is needed. I was gearing this article towards novice investors, in an attempt to highlight how difficult it is to accurately value companies that are very new and/or that have a very small market capitalization.

    Hope this helps and I hope you enjoyed the article.

  8. Anon says 29 December 2006 at 21:05

    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 being a $2.00 stock. Why not just say, “If you purchase a stock, you are gambling – you are not investing.”

  9. Brian says 08 May 2007 at 03:23

    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.

  10. Mr.Magoo says 27 January 2008 at 02:19

    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!!!

  11. Louis Shain says 26 February 2009 at 13:27

    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 200%, verses the market being down thus far.

    Although I do believe almost everything you say about penny stocks, I am a firm believe that you can capitalize on quick trades if you don’t treat them like investmenst.

    I normally check out for information among others, but that is a decent start.

  12. Bryce says 23 October 2009 at 14:43

    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…..

  13. Shawn says 01 January 2010 at 00:14

    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 make tons of money like me and Bryce have made. LOL

  14. Shawn says 01 January 2010 at 00:26

    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. LOL

  15. henry@penny stocks says 24 March 2010 at 02:36

    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.

  16. KeNclousezels says 01 November 2012 at 14:20

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  17. KeNclousezels says 02 November 2012 at 10:18

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  18. John says 14 January 2013 at 03:46

    As an author you will never make money, EVER.

  19. Ken Roberts says 01 June 2013 at 20:54

    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 them like a hawk. Not “Fred’s Gold Mining, Inc” of course, but stocks such as FNMA. Pennies for a stock whose company had revenues exceeding Apple and Google this year!!

  20. Jamie Aranoff says 11 June 2013 at 06:15

    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 bankrupt. Genworth Financial dropped to $0,25 cents only to pop to over $14 over a period of 2 years.

    Yes, you can lose money in small business and in penny stocks. If you are afraid of risks stay away from both. In 2009 I bought this “expensive” penny stock at $0.55 that popped in a matter of 3 months to over $3.50, my selling point was $2.75. I would not get the same results with caterpillar or coke. Unusually enough, or perhaps not so, I learned about my penny stock gems in Yahoo Message boards, I do my due diligence ahead of buying. Profits come around and is time to sell. Jazz Pharmaceuticals was once $0.70….take that Caterpillar!

  21. John Douglas says 28 August 2013 at 23:39

    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 says 03 November 2013 at 14:05

      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 company in growth. And if the company’s you invest in have multiple projects in the pipeline the chances of succeeding are fair. Don’t put all your money into penny stocks but a buy, hold and wait strategy before the company is discovered by the mainstream has multiple upside potential. Buying stupid cheap stock and selling the stock in a bubble does work.

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