The ultimate look at how to invest in penny stocks

Fundamentals 09: The article looks at various issues when investing in penny stocks - whether it is bad, illegal. It explores what differentiates penny stocks from others and how you can benefit from these.

"Bottoms in the investment world don't end with four-year lows; they end with 10- or 15-year lows." Jim Rogers

Penny stocks are generally considered to be speculative and high risks.

The first impression of a penny stock is that it is one that has fallen from some high price (Fallen penny stocks). The connotation is that there must be something wrong with the company for the share price to fall and hence is a risky investment.

But in many countries, there are also stock exchanges that allow IPO at penny stock prices (IPO penny stocks). The investment risks in such penny stocks are different from the Fallen penny stocks.

Then there is the issue of what makes up a penny stock. Some countries have an official definition of a penny stock. But I would argue that penny stocks have to be seen from the perspective of the retail investor.

So, if you want to invest in penny stocks, you have to dig deeper to understand the reasons why they are penny stocks. Only then can you put the risks and returns in the appropriate perspectives. Thereafter you can develop the appropriate investment strategies and risk mitigation measures.

There are two ways to invest in penny stocks:

From a long-term value investment perspective. Sometimes companies trade at penny stock prices that do not reflect the business fundamentals. Investment opportunities here cover both the Fallen penny stocks and the IPO penny stocks.

From a trading perspective. You view them as buying and selling pieces of paper and you think that penny stocks offer the best potential for speculative gains. Again, there are opportunities from both categories of penny stocks.

I will explore both investing options in this article.

While I am approaching this as a beginners’ guide to penny stocks, or penny stock 101, it requires a certain level of expertise to invest in penny stocks.

If you do not have such expertise but still want to select individual stocks you should rely on the advice of those with such expertise.

Those who can help include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

1. What is a penny stock?

2. Can stocks be issued at penny stock prices?

3. What causes stocks to become penny stocks?

4. Why are penny stocks risky?

5. How are penny stocks regulated?

6. Why are investors attracted to penny stocks?

7. How to invest in penny stocks

8. How do you make money from penny stocks?

9. Can you get rich off penny stocks?

10. Summary

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1. What is a penny stock?

A penny is a unit of currency in some countries. It is usually the smallest denomination within a currency system. It is the official name of the British penny and the informal name of the American one-cent coin.

You may think that a penny stock is one that is trading in pennies or in the smallest denomination of a currency.

“If something is pennies on the dollar, it's much cheaper than it cost originally”. UsingEnglish.com

If you owed someone money and you settle this for “pennies on the dollar”, it means that the lender has accepted much less than the original amount.

There is the connotation that there is a drop in value if something is “pennies on the dollar”. But, when it comes to penny stocks, the connotation that there is a drop in value does not necessarily apply.

It is generally accepted that a penny stock is one whose price has declined so that it is now a fraction of the original cost or the peak price. At the same time, there are actually IPO of stocks at “penny stock” prices.

Given this scenario, a more realistic meaning of a penny stock is one that is trading below some nominal price. I use the term “nominal” price because “pennies on the dollar” have to be taken in the context of the currency of the stock exchange.

For example, for Bursa Malaysia, a penny stock is generally one trading at less than RM 1. In India, although there is no formal definition of a penny stock, those that trade at less than Rs 10 are considered penny stocks.

In the US the public may think of penny stocks as those trading below USD 1. But, the US Securities and Exchange Commission (SEC) defines a "penny stock" as a security that trades at less than USD 5 per share.

Furthermore, when you look at the nominal price of penny stocks, you may have to look from a retail investor's perspective. A retail investor's idea of a penny stock is one where he invests pennies and hopes to reap some multi-baggers quickly.

If you take this view, a penny stock is one that must be trading at some large discount to the retail investor's idea of a “normal” market price. The real question is what is a “normal market” price.

I would like to offer one possible reference of the “normal market price” by looking at the average transaction price of shares.

For Bursa Malaysia, the average transaction price in 2020 was RM 1.40 per share.

For Nasdaq and NYSE, the average transaction price in Q1 2021 ranged from USD 50 to USD 60 per share.

If you take 10% as the reference, then penny stocks in Malaysia would be those trading below RM 0.14 cents per share. But, those in the US would be trading below USD 5 per share.

What does all this mean when you want to invest in penny stocks? The first step is to know the nominal price that the market considers as a penny stock. It does not mean a share that is trading in only in pennies.

2. Can stocks be issued at penny stock prices?

It is ironic that the largest stock market in the world - the USA - allows for an IPO price to be below the US SEC definition of a “penny stock”.

To qualify for listing on the NYSE, a company must have at least 400 shareholders. It must have at least 1.1 million shares available to the public and a market value of the public shares of at least $40 million. Each stock must have a minimum value of $4 at the time of listing. Zacks.

The regular bid price of shares of the company's stock at the time of listing on Nasdaq must be at least $4. However, a company may qualify under a closing price alternative of $3 or $2 if the company meets varying requirements. Investopedia.

Compare these with the US SEC definition of a penny stock as a security that trades at less than $5 per share.

In Malaysia, most of the companies listed under the ACE or LEAP market have IPO prices less than RM 1 per share.

As such, when you want to invest in penny stocks, you need to differentiate between:

Those priced as penny stocks at the IPO stage.

Those that became penny stocks due to the fall in prices.

The risks and returns are different.

3. What causes stocks to become penny stocks?

There are two categories to consider for this question.

Those who undertook the IPO at penny stock prices - the IPO penny stocks.

Those that because penny stocks due to a fall in the stock prices - the Fallen penny stocks.

3.1 IPO penny stocks

All stock exchanges have IPO rules for market value, shareholding spread, and business performance.

There is a mathematical relationship between the amount a company wants to raise, the market price of the share, and the above parameters.

For example, if you want to raise $20 million and you want 20 million shareholders, the price per share will have to be $1. If you want 40 million shareholders, the price per share will have to be $0.50.

For a small company (from profits and/or capital employed perspective) the IPO price will be at penny stock prices.

3.2 Fallen penny stocks

These are companies that IPO at non-penny stock prices but whose business prospects have since deteriorated. The market has reacted and they are now trading at penny stock prices.

For Bursa Malaysia, Parkson Holdings and Whitehorse currently fall into this category. In the case of Parkson Holdings, the share price has declined as their department store businesses are facing a digital threat. In the case of Whitehorse, its business has been affected by the soft property and construction market.

For the US, Nokia and Kodak that were once “blue chips” are now trading at penny stock prices due to a deterioration of their businesses. OK, Kodak prices popped in Feb 2021 when there was some news about Kodak working with Microsoft.

The key difference between IPO penny stocks and Fallen penny stocks is that the latter is not some small or micro-cap companies. So, the risks and business prospects are different.

4. Why are penny stocks risky?

There are two schools of thought when it comes to risk.

Those that view it as volatility.

Those that view it as a permanent loss of capital.

I am a long-term value investor and as such, I generally ignore the former and focus on the latter. However, when you invest in penny stocks, you need to consider both. This is because penny stocks are generally very volatile and also that you may not hold them for long.

4.1 Volatility

Penny stocks tend to be small-cap or micro-cap stocks and by virtue of the sizes, they are often considered to be more volatile.

“Small-cap stocks can be quite volatile… as measured by the CBOE Volatility Index... The chart below shows the small-cap-focused Russell 2000 Index tends to lose more value, too, during bear markets, as compared to the large-cap benchmark S&P 500. The movements of the Russell 2000 Index are also comparatively more exaggerated...” The Motley Fool

There are a number of reasons why smaller companies are more volatile.

“Smaller companies… tend to have a tighter business focus. They may have the potential for more rapid revenue and profit growth, but this potential is often more variable. As a result, small-company shares may, on average, be more volatile and more sensitive to macroeconomic shifts than the shares of larger companies”. Fidelity

But volatility does not mean lower returns.

4.1.1 Small-cap stocks and returns

While small-cap stocks have higher volatility compared to larger-cap ones, they have better returns.

In 1992, Eugene Fama and Kenneth French published “The Cross‐Section of Expected Stock Returns”. They opined that size and book-to-market equity explained a significant part of stock market returns.

This small-cap effect is one of the reasons why despite its volatility, small-cap stocks are favored by many investors.

“In the period from 2003 through 2013, the volatility of small-cap funds as measured by standard deviation was 19.28. For large-cap funds, it was 15.54. Over the same period, small-cap funds yielded an average annual return of 9.12%, and large-cap funds yielded a return of 7.12%.” Investopedia

However, the results are in the context of investing in small-cap stocks as a group and not individual stocks. At the same time, the definition of small-cap stocks is not necessarily the same as penny stocks that many would classify as micro or nano stocks.

More importantly, volatility only turns into a permanent loss of capital if you sell. If you can hold until prices recover, you may not suffer a permanent loss of capital.

4.2 Permanent loss of capital

If risks are not volatility but permanent loss of capital, why are penny stocks more prone to such losses?

From a fundamental perspective, the IPO penny stocks tend to be in earlier stages in their life cycles than large-cap companies. This means that they are more likely to be unprofitable.

They tend to derive value from their growth potential rather than existing assets or profits. But the growth potential may never be realized.

They tend to underperform in bad times. This is because they do not have the same resources as large companies that can survive unexpected crises.

They cannot borrow money as easily as big companies and are more likely to have negative cash flows. So, they have a greater chance of going bankrupt during market contractions.

As for the Fallen penny stocks, they can become penny stocks due to a deterioration of the business fundamentals. In such cases, they are undergoing a turnaround. The challenges for such companies are more severe than those whose prospects have not deteriorated.

But, if the Fallen penny stocks are because of the market over-reacting, the business risks are limited. An example is what happened in Mac 2020 due to the Covid-19 pandemic.

The following are often cited as reasons why penny stocks are risky. But the market has confused the issues as not all are appliable to both categories of penny stocks. Judge for yourself.

Liquidity.

Lack of information.

Different standards.

4.2.1 Penny stocks are less liquid

Because of their penny stock status, many funds are not able to invest in penny stocks. Secondly, because of the negative connotation, many investors also shy from investing in penny stocks.

All these mean that penny stocks have low liquidity. You won't be able to sell the stock easily and may have to lower the price until it is considered attractive to another buyer.

Penny stocks thus have larger ask/bid price spreads that may make it more difficult to make money.

There is another problem with low liquidity. They provide opportunities for stock manipulation. For example, under a pump and dump scheme, someone could buy large amounts of stock, hype it up and then sell it after other investors find it attractive.

4.2.2 Penny stocks may provide less information

IPO penny stocks come under different stock exchange rules than non-penny stock counterparts. Invariably there are fewer rules on disclosure.

If you are investing based on fundamentals, you want to have enough information to make an informed decision. For some penny stocks, information on corporate performance can be very difficult to find.

Note that this is would not be the case for the Fallen penny stocks.

Also, if you are investing based on technical analysis, the lack of company performance information should not be an issue.

4.2.3 There are less stringent regulatory standards for penny stocks.

In many countries, if a company IPO as a penny stock, it comes under a different stock exchange.

For example, those that IPO under the ACE or LEAP guidelines (secondary boards) in Malaysia are reported separately from those under the main market.

In the US, although some penny stocks trade on large exchanges such as the NYSE, most penny stocks trade over-the-counter (OTC) through the OTC Bulletin Board.

The regulatory requirements under these “secondary” boards are different and less stringent than those of the “main” boards.

Minimum standards can act as a safety cushion for some investors. When a company is not subject to higher standards, investing in that company becomes much riskier.

Many of these IPO penny stock companies could be newly formed, and some may have poor track records or no track record at all. As you can imagine, this lack of historical information makes it difficult to determine a stock's potential.

In conclusion, when assessing the risks of investing in penny stocks, you should:

Differentiate between the IPO penny stocks and the Fallen penny stocks.

Consider the investment style eg fundamental vs technical.

5. How are penny stocks regulated?

If you understand that they are two categories of penny stocks, you will have a better understanding of how they are regulated.

In many countries, there are different stock market categories to serve different market segments. Many differentiate by the size of companies. For example:

In the US, you have the OTC Board for the penny stock companies and the NYSE or Nasdaq for the non-penny stock companies.

In India, you have the mainboard and the SME board.

In Malaysia, you have the ACE for specific industries especially the tech. You also have the LEAP for the SME while the bigger companies are listed under the mainboard.

For those that IPO as penny stocks, they are governed by the rules of the stock exchange or board they are listed under.

For the Fallen penny stocks, if they have not been transferred to the secondary boards, they are still governed by the rules of their original board.

Each board has its respective rules. However, the secondary boards generally require less disclosure.

The non-main board companies may not provide the necessary information for investors. This is especially for fundamental investors who require more information.

6. Why are investors attracted to penny stocks?

I find that there are many questions on Quora by newbies about penny stocks. I suspect that the interest is because they believe there is less downside. They find smaller and newer companies less intimidating. Also, they expect such investments to be more attainable and appropriate for their level of trading experience.

There are those who think that by investing in penny stocks newbie can have more investments. They think that they can get more exposure and a broader learning experience within a short period of time. Furthermore, penny stocks being more volatile enable newbies to learn faster.

Investopedia has other reasons for the interest in penny stocks.

Many believed that many of the big companies today were once penny stocks. Amazon IPO at USD 2 per share. In the early 2000s, Apple was trading at USD 0.80 per share. They hoped to find the future Apple or Amazon.

Many believe that there is room to own more stocks that can appreciate a lot. Of course, they often forget the downside.

The various reasons offered for why investors are attracted to penny stocks can be easily refuted.

Intimidating - you are intimidated because you do not know how to invest.

Attainable and appropriate - you should not invest or trade without first learning how to do so.

Learning experience - I fail to see why a newbie must spend money to practice what they have learned. You could paper trade and get the same learning experience without having to spend real money.

There are many apps and platforms today that enable you to invest fractional shares. Why would you then want to take on additional risks by investing in penny stocks if your focus is on spreading your money to more shares?

I think that the people who are attracted to penny stocks just look at the upside. It is more of a buying-lottery mentality - they think they can afford the loss and the upside is too good to miss.

7. How to invest in penny stocks

When you invest in penny stocks, you have to remember why they are different from other types of stocks.

Basically, apart from being very low priced, penny stocks are more volatile, are less liquid, have wide ask/bid price spreads, and are prone to scams. From a fundamental perspective, they have a poorer track record and are probably less transparent.

There are two main ways to invest in penny stocks - based on fundamentals and based on technical analysis.

7.1 How to invest in penny stocks using fundamentals

Here you invest from the perspective that you are buying and selling part ownership of a business. You look for opportunities where the price of the penny stock is trading at less than the value of the underlying business. You determine this by looking at the fundamentals.

If you are not able to analyze the company and/or value it, you should not invest. This is the most important principle irrespective of whether it is a penny stock or not.

I have invested in penny stocks and some of the case study companies covered in this blog (eg Eksons and New Toyo) are penny stocks.

But my penny stock investments are based on the companies being identified as value stocks. It is not because they were penny stocks per se.

The low prices were not relevant considerations. What was considered were:

The business prospects.

They were trading at a significant discount to the intrinsic values.

All my penny stocks were Fallen penny stocks. I have not invested in IPO penny stocks.

I do not consider volatility, low liquidity, and larger ask/bid price spread as important issues as I am a long-term investor. I am confident that these risks pale in comparison to the gains.

My advice is very straightforward. Analyze and value penny stocks as you would do for any company. There is no reason to change your analytical and valuation approach. If they pass your assessment, then invest.

If there is anything particular, it is that if it is a Fallen penny stock, it is likely to be facing a turnaround. This makes it riskier and I have a larger margin of safety compared to a more conventional quality value company.

If it is an IPO penny stock, consider it only if there is enough track record and other information available for you to analyze and value it. If you reach such a stage, the fact that it is an IPO penny stock is irrelevant.

7.2 How to invest in penny stock using technical analysis

Your approach here is that you are buying and selling pieces of paper. This is a market sentiments-driven approach and your success depends on your ability to read market behaviour.

This is a short-term investing strategy. Many would call it trading or speculating rather than investing.

I do not want to get into the debate of whether this is an investment or speculation. The key point is that you make money from price action. You use whatever tools you have to identify stocks whose prices are likely to go up.

While I have learned technical analysis, I have not been able to make money with trading based on technical analysis. I am not the best person to advise you on how to trade with penny stocks using technical analysis.

However, for this article, I have researched using technical analysis for penny stocks. I wanted to see whether there are any identified techniques or analyses that are meant for penny stocks.

In order words, are there any special chart patterns, or technical indicators that you use for penny stocks? This is considering that they are more volatile, less liquid, and prone to scams.

I have not found any articles that identified specific techniques or analyses for penny stocks. Rather the advice and analyses are applicable to trading non-penny stocks.

The only differentiating point I could find was that you have to screen for penny stocks with larger trading volumes. This is to overcome the liquidity issue.

How should you trade with penny stocks then?

Unless you are an experienced trader and/or have stock trading skills, you should not trade with penny stocks. Do not be mesmerized by the low prices.

Your penny stock trades should be part of your portfolio of trading stocks. I would recommend that they are a smaller part of your portfolio.

Trade those penny stocks with bigger transaction volumes. I would suggest that you focus on the top decile of penny stocks (ranking them by past year transaction volume).

Do your own analysis and avoid tips for these could be part of a scam.

Pay attention to the stock-broking fee structure because of the ask/bid price spread. Choose stockbrokers that offer a flat rate per trade rather than those that charge commission on a per-share basis.

If you really want to gamble ie looking for the next Amazon, then invest with money that you can afford to lose. Treat it as equivalent to buying a lottery ticket.

Remember that you are investing based on popularity and not the business prospects of the company. Focus all your efforts in trying to read crowd behaviour and do not be distracted by fundamental issues.

8. How do you make money from penny stocks?

It is obvious that to make money from penny stocks, you first need to find someone to sell them to you at a bargain price.

If it was so obvious that there is some event that is going to make the stock more popular, you will have difficulty finding a seller.

If you are investing in penny stocks from a fundamental perspective, you are likely to be a contrarian investor. You invest at a time when nobody wants to touch the penny stock.

I would imagine the same scenario if you are investing based on technical analysis. If all the charts and indicators point to an upturn, it is probably too late to get in. You have to look for some price action signals that the crowd did not see. Can you find such a signal or would your success in investing in penny stocks due more to luck?

There are those that believe that there are lots of information inefficiencies with penny stocks so it is possible to catch part of the move.

CNN had an article about two traders who were successful in trading penny stocks. One of the techniques is to get in front of a pump and dump scheme.

"I think it's mainly for people who are gamblers…But at casinos you play with low odds. With penny stocks, there are patterns that are very predictable."

You probably have better odds investing in penny stocks from a fundamental perspective than from trading in penny stocks.

9. Can you get rich off penny stocks?

This question is about whether you can get rich by focussing on penny stocks.

If you invest globally, there will always be a lot of Fallen penny stocks and IPO penny stocks.

If you invest based on fundamentals and develop a contrarian approach, you can achieve good returns. This is based on the track record of value investors.

Given consistent good returns and a long-term investment horizon, you would be able to compound your wealth. So yes, you can get rich off penny stocks.

The CNN article I referred to earlier showed that there are some people who have gotten rich trading penny stocks as well.

The points to remember about getting rich off penny stocks are

You need to develop the appropriate investing skills.

You need to reinvest your gain to benefit from the power of compounding.

10. Summary

A penny stock is a stock that is trading at a fraction of the average market price. We can of course debate about what is the average market price. Yet, there are “markets” understanding about what makes up penny stocks.

In the US, penny stocks are defined as those trading less than USD 5 per share. In Malaysia, the general understanding is those trading less than RM 1 per share. But the purists would only consider those trading in the low cents per share.

There are two categories of penny stocks - the IPO penny stocks and the Fallen penny stocks.

The way you would invest in penny stocks should not be any different from the way you invest in non-penny stocks. You can invest based on fundamentals or use technical analysis.

Just that it is more challenging to undertake the appropriate analyses for penny stocks. This is because of the characteristics of penny stocks - volatility, less liquid, larger ask/bid price spreads.

To make money from investing in penny stocks using fundamentals, you have to be a contrarian investor. To gain from trading in penny stocks, you have to make use of the information efficiencies to get ahead of the crowd.

Given all the above, you can see that there is no moral issue (good, bad) or legal issue about investing in penny stocks.

If you are not going to have any spectacular gains from penny stocks, why select them when you have more non-penny stocks to choose from. And especially if there are platforms that enable you to buy fractional shares of non-penny stocks.

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I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.

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