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What Is A Penny Stock And Why Do They Matter?

Views 3212022.11.10

Key Takeaways

Penny stocks can be invaluable investments within a wider portfolio, but their inherently volatile nature means investors need to carry out their due diligence before making an investment decision. Here’s our guide to penny stocks and how they can play a role in your investment portfolio.

What is a Penny Stock?

Penny stocks refer to smaller stocks trading within stock markets. The official definition by the US Securities Exchange Commission (SEC) defines penny stocks as any security that’s trading below $5 a share.

It’s common for penny stocks to be relatively new companies that have a smaller market capitalisation. Without an established track record, these companies present riskier endeavours, leading to a lower stock value.

Penny stocks can offer strong investment opportunities, particularly for those who don’t have a significant amount of capital to invest with. Penny stocks have achieved significant results in the past in terms of exponential growth, offering the chance for new companies to see rapid gains in value.

However, as with any investment, penny stocks can also offer sizeable risk. Their volatility means investors can stand to lose some or all of their investment, meaning astute investors need to carry out significant research before making the decision to invest.

Understanding Penny Stocks

Penny stock investors may fall into the trap of believing that a low share price indicates more growth potential within that stock than a company with higher share prices. This isn’t necessarily the case, with market capitalisation (the valuation of a company) the result of two distinct factors: the stock price and the number of shares outstanding.

The second factor is entirely within the control of the individual company, with full authority over how many shares to issue within their hands. If investors aren’t aware of this, they risk investing in shares without a clear understanding of their value.

In fact, the potential risk to investors is made explicit by regulatory authorities, with the SEC stating ‘investors in penny stocks should be prepared for the possibility that they may lose their whole investment.’ While this is, of course, potentially the case with all stock investments, penny stocks can represent a more significant risk of a total loss of value.

Example of a Penny Stock

A recent example of a penny stock that’s experienced a massive uptick in stock value is Cassava Sciences, Inc. (NASDAQ: SAVA). This company is a clinical-stage biopharmaceutical company that’s focused on neuroscience, translating novel scientific insights into new medicines. Cassava Sciences state that their mission is to detect and treat Alzheimer’s disease, with a focus on achieving detection of Alzheimer’s that’s as simple as getting a blood test.

This stock was recently in the penny stock range, but across 2020-2021, it recorded a gain of over 4000%. While not every penny stock will achieve such a significant amount of growth, this is a clear example of why so many investors look to penny stocks in the hopes of seeing a strong return.

How is a Penny Stock created?

Penny stocks are created the same way other publicly traded stocks are, through an initial public offering (known as an IPO). For new, smaller companies or startups, the issuing of stocks is often used as a means of building accessible capital quickly.

In Australia, penny stocks are the smaller companies as per market cap on the ASX, and are also known as ‘small cap stocks’.

Should you invest in Penny Stocks?

It’s important for any investor considering penny stocks to recognise that, as with any stock, penny stocks bring with them inherent risk. Penny stocks are also viewed as more volatile than traditional stocks, as many investors fall into the low-price fallacy (believing that low-priced securities are cheaper than higher-priced ones), are quick to believe that a low price means a guaranteed increase, or are more ready to invest without substantive research and consideration based on the lower stock value.

Ultimately, penny stocks are equally likely to make large gains as they are to result in large losses. For investors who are able to assess their risk appetite alongside the possibilities of a return from an individual penny stock, they’ll be more likely to invest in a stock that aligns with their overall investment strategy, minimising the risk of a loss on a speculative, uninformed investment decision.

Regulations for Penny Stocks

Given the speculative nature of penny stocks, industry bodies have introduced a number of rules that regulate their trading. In the US, for example, the SEC and Financial Industry Regulatory Authority require broker-dealers to comply with the following rules:

The broker-dealer is required to approve the investor’s transaction and ensure the investment is suitable for that investor’s purchase

The broker-dealer must give the customer a standardised disclosure document, detailing the risks associated with purchasing penny stocks, customer rights, and pathways to solutions should fraud take place

Broker-dealers are required to disclose and confirm current quoted prices before they’re legally able to complete a penny stock transaction

A broker is obligated to disclose to the investor the funds the broker will earn from the transaction facilitation

Brokers are required to provide investors with monthly account statements, including details such as the penny stock’s limited market liquidity and an estimate of current share value within the limited market

Advantages of Penny Stocks

Penny stocks can offer investors and companies with many advantages. These include:

Funding for small companies

Penny stocks are an invaluable method of providing small companies with access to funding from the public. It’s common for companies to use penny stocks as a means to then move into a larger marketplace. This has positive outcomes for diversification of companies and competition, enabling more companies to take part in commercial enterprises with access to funding opportunities and pathways.

High potential for growth

While no growth is guaranteed in a penny stock, they do offer investors the chance of a notable upside. Some of the world’s largest and most successful companies began life as penny stocks before growing into blue-chip companies, including Amazon. For investors with a healthy risk appetite, or those who are able to spot emerging trends within particular industries that a penny stock may address, penny stocks can provide opportunities for significant growth outcomes. However, investors must remember that these securities are often more risky than established companies, and shape their strategies accordingly.

More affordable

As penny stocks are generally worth less than 5 dollars per stock, they can offer investors a more affordable pathway into the stock market. Penny stocks may be of value to those with limited amounts of capital who are still looking to invest, providing not only access to ownership of stocks, but educational experiences through the investment’s trajectory.

Allows you to invest in niche industries

Penny stocks also give investors the opportunity to invest in niche industries, familiarising themselves with smaller companies who may be active in spaces with emerging technologies. If you’re looking to learn more about a particular niche or to build a new stock into your portfolio, penny stocks enable investors to enter into a position without significant capital requirements.

Gives you diversification

Penny stock investment is a great way for investors to diversify their portfolio, creating exposure to varying fields and spaces. Penny stocks are often desired alongside blue-chip stocks in order to give investors a mixture of stable, long-term growth prospects and stocks that have the potential for short-term gains and growth.

Disadvantages of Penny Stocks

Alongside the advantages of penny stocks, they also have disadvantages that must be weighed up by investors as a part of their purchasing strategy. These disadvantages include:

Penny Stock volatility

As this form of stocks is likely to represent a growing company that has limited or fluctuating access to cash and resources, they’re more likely to present a high degree of volatility. While this does result in a higher potential for reward, it also paves the way for a higher level of potential risk.

Investors must be willing to accept the risk of potentially losing their entire investment on a penny stock (or even more than their initial investment if they buy on margin). For this reason, investors need to ensure they’re considering the risks associated with penny stocks, with protective mechanisms such as stop-loss orders in place in order to mitigate these risks as much as possible.

Why do Penny Stocks fail?

While some penny stocks will realise significant profits, others are destined to fail. This risk is an inherent part of the nature of penny stocks. For investors looking to assess the likelihood of a successful penny stock trade, these factors are worth considering:

Lack of information available to the public

For those looking to complete technical analysis on individual penny stocks, they must have access to substantial data in order to complete an assessment of that stock’s likely value. For many companies who issue penny stocks, finding access to that level of data and information can be challenging, as they’re less likely to need to meet stringent information disclosure standards like their larger, established counterparts.

No minimum standards

Many exchanges have minimum standards that any trading company must meet in order to remain active on that exchange. Should prices fall outside of these minimum standards, companies risk being delisted from major exchanges, instead moving to smaller exchanges where they’re likely to be placed under fewer restrictions.

Companies who issue penny stocks may also be more likely to have weakened financial structures and unproven business plans than traditional, established stocks, given the nature of new and smaller companies.

Lack of history

Newer companies without a proven track record can make it difficult for investors to build fully informed assessments of the stock’s potential for sustained and continued growth.

Liquidity and fraud

Lessened regulation means penny stock companies may be more targeted by scammers looking to turn a quick profit. As social media continues to grow in its influence on the investment choices of certain traders, they may be more prone to being misled due to an intentional move by a micro-cap company to raise their stock’s value.

Stocks that don’t trade frequently may not have much liquidity, meaning investors may not be able to sell the stock after they’ve acquired it. This means investors may be forced to reduce their price until it’s accepted by a buyer, leading to profitability issues.

Low trading volume

Stocks with low trading volumes can present multiple risks to investors, including the risk of low liquidity, challenges in realising a potential profit due to the low trading volume, an indication of a deteriorating company reputation, stronger susceptibility to artificially inflated prices and the likelihood of being targeted via a ‘pump and dump’ scheme.

Tips for investors

Even with the volatility inherent within penny stocks, investors looking to make use of these particular stocks can take strategic steps to mitigate their potential risks. By making the most of these tips, you can stand to benefit from an informed approach to the penny stocks available on the market.

Do your research

Perhaps the most obvious tip for investors is to do your research! Without proper due diligence, penny stocks represent even more of a risk, as they may detrimentally impact an overall investment strategy. By reading company statements and carrying out the necessary research to ensure the company in question is financially reputable, investors can remove some of the guesswork involved in speculative penny stocks investments.

Plan a strategy and stick to it

Rather than investing via a shotgun approach, investors who plan a clear strategy and remain committed to it are more likely to see returns over the long run. As penny stocks are volatile, investors who can ride out short-term gains and losses are more likely to profit over the long term.

Don’t make emotional decisions

Emotional trading is never recommended by experts across the traditional stock market and penny stocks alike. Emotional trading can create unnecessary exposure to risk, with emotions blurring the investor’s ability to focus on key indicators of performance via technical and fundamental analysis. As well, emotional traders are more likely to respond to smaller movements in the market, rather than looking to a long-term forecast in order to trust an ongoing bull or bear market strategy.

Cheap doesn’t always mean value for money

Just because a penny stock may be cheap doesn’t mean it guarantees strong value for money. It’s important to remember that there’s a reason why penny stocks are valued where they are: often, the business behind the stock warrants that cash value. These companies are more likely to work from a limited resource base with higher rates of volatility, meaning cheap doesn’t always equal a positive outcome with guaranteed returns on investments.

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