Penny Stock Investment - For Experienced Investors Only!

Penny stock investment is high-risk investment in stocks priced less than $5 and traded outside regular stock market exchanges. It is often connected with scams.

Penny stock investment is considered as investment in common stocks, which are priced less than $5 (some definitions limit penny stocks as less than one dollar per share). Second criteria defining penny stock investment is that they are listed outside one of the major exchanges (NYSE, NASDAQ, or AMEX); instead, they are traded in the Pink Sheets or over-the-counter (OTC) Bulletin Board market. In addition, a true penny stock will have less than $4 million in net tangible assets and will not have a significant operating history.

Every investor must be aware, that legitimate information on penny stock companies can be difficult to find and the underlying equities can be easily manipulated; therefore you must be very careful when investing in penny stocks.

Are Penny Stocks a Good Buy Because They Are so Cheap?

Penny Stock Investment

Many beginner investors consider stock price in absolute terms when comparing to price of other stocks. Very common and wrong thinking is, that stock of Google share worth $500 is expensive compared to Cisco share for example, which is worth "only" $23 per share. The same logic is then applied to penny stock investment; just because a stock sells for $1 a share, many investors consider it as cheep and with huge potential. Also do not assume that just because a stock sells for $1 a share that it is a worthless company to invest in.

You must be aware, that price of the stock in absolute terms tells you absolutely nothing about how undervalued or overvalued the stock is. You have to compare the stock price to earnings the company is generating, growth, assets, dividends, etc. Like any investing venture, you must do your research and your homework before making any financial decisions. Stock price itself should not be the sole factor on which to make this decision. It is no indicator of past or future performance of a company.

Penny Stock Investment Is High-Risk Investment!

The SEC warns that penny stocks are high risk investments and new investors should be aware of the risks involved. These risks include limited liquidity, lack of financial reporting, and fraud.

Liquidity Risk

A lack of liquidity can make penny stock investment more vulnerable to price manipulation, and increases the difficulty investors might have to sell their shares as there may be few or no buyers at any point in time. Sudden changes in demand or supply of low-priced shares can lead to volatility, and potentially cause major percentage moves to the upside or downside. Besides being significant in size, such price spikes or dips may occur over very short time frames, whether that means weeks, or days, or hours. Penny stocks are also susceptible to price manipulation, especially when there is few or only one market maker.

Financial Reporting Risk

Unlike NASDAQ or the NYSE, there are only minimal requirements for an equity to be quoted on the OTCBB, and even less to garner a listing on the Pink Sheets market. Companies that fail to meet minimum standards on one of the broader exchanges, such as timely filing of financial reports, investor relations and communications commitments, and are delisted as a result, often relist on the OTCBB or the Pink Sheets.

Any company whose shares are trading on the Pink Sheets (recognizable with a .PK suffix by some brokers and quoting services) has little to no regulatory or listing requirements whatsoever. There are no minimum accounting standards, change in notification of ownership of shares, and reported other material changes affecting the financial viability of a company, all of which are designed to protect shareholders.

Fraud Risk

Penny stocks are often promoted as part of illegal "pump-and-dump" schemes, which runs by subsequent scenario:

"A company's web site may feature a glowing press release about its financial health or some new product or innovation. Newsletters that purport to offer unbiased recommendations may suddenly tout the company as the latest "hot" stock. Messages in chat rooms and bulletin board postings may urge you to buy the stock quickly or to sell before the price goes down. Or you may even hear the company mentioned by a radio or TV analyst. Unwitting investors then purchase the stock in droves, creating high demand and pumping up the price. But when the fraudsters behind the scheme sell their shares at the peak and stop hyping the stock, the price plummets, and investors lose their money. Fraudsters frequently use this ploy with small, thinly traded companies because it's easier to manipulate a stock when there's little or no information available about the company."

Other common scams include sale of chop stocks to overseas or domestic retail investors, spam e-mails and junk faxes that tout ludicrous and fraudulent claims, crooked newsletter writers who promote a stock for a fee, message boards swarming with "buy now!!!" postings about a stock from anonymous, paid posters, fake or misleading press releases issued by the company, or boiler rooms full of cold-callers targeting naive, elderly, or foreign buyers all in attempt to drive up the share price just before the insiders sell.

While there were very serious concerns in recent years of organized crime gangs manipulating prices of equities, these issues are no longer of great concern. Greater investor knowledge, combined with domestic and international cooperation and crackdowns, have seen an almost complete reduction in such illegal practices from previous years.

Legitimate Penny Stocks

Despite all of the problems with penny stocks and penny stocks the millions of dollars of loss involved with them, there are legitimate companies whose securities trade in the pink sheets at very low prices. Struggling young companies just starting out are perfect examples. The major question is how to differentiate good penny stocks companies from bad ones?

In order to choose the right company, you must know something about the business in which the company engages. You must be able to evaluate the feasibility of the company's business plan and the company's ability to compete in its field with other players. You must be able to evaluate the ability of the company's management to run the company. Finally, you must be able to evaluate the capitalization and cash flow of the company.

Another important factor when investing in penny stocks is, that you have to have sufficient capital and enough time for such investment. You must be able to hold the investment for years and allow the company to mature and for the stock to appreciate in value. Investment in "growth" companies is long-term investment.

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