Investing in penny stocks is the dream of every trader. Where else can a single investment blow up and double, triple, quadruple or more practically overnight. But, is that reality or fantasy?
The Dream
Penny stocks can be wildly profitable. On the morning of April 6, 2001 Concur Technologies (NASDAQ:CNQR), a software company specializing in employee expense accounting, opened at 38 cents per share. By September 19, 2008, in the midst of a global market meltdown, Concur shares were selling for $50 per share. In seven years, the stock appreciated by 13,200 percent.
Another example is ImClone (NASDAQ:IMCL) of Martha Stewart fame. You could have purchased ImClone for 18 cents per share on February 24, 1995 (9 cents per share adjusted for the 2:1 split on October 16, 2000) and sold it for over $86 per share on July 2, 2004, an increase of over 95,000 percent. A $1,000 investment made at the low would have been worth almost $1,000,000 at the high, in less than ten years. The stock still trades well above $50 per share today.
The Reality
For every tale of penny stock success, however, there are thousands of penny stock companies that completed their trek to zero, taking all their investor's money with them. The fantasy of penny stock millionaires rarely trumps the reality of the market's composition of under-capitalized, poorly managed companies. In other words, if a stock is trading for pennies per share, there is almost always a good reason for it.
After everything is said and done, the stock market is a pretty efficient beast. Since the onset of the Information Age, changes to the fundamental values of any given company are quickly factored into the current price per share. In many cases, the changes are factored into the price in anticipation of a given event, such as earnings releases, drug approvals, insider buying or selling, or any other event that can impact a stock price. Giving rise to the saying, buy the rumor, sell the news.
With that in mind, if a stock is trading for five cents per share, it probably should be. The myth of a diamond in the rough, or a pony buried in a pile of manure, is often just that – a myth. Individual investors need to be realistic with their hard-earned investment dollars. If FlimFlam Labs really did have the cure for cancer or Fugazzi Energy could really power a car with sea water, do you think that you be the only person that knew about it?
The Strategy
In light of the market crash of 2008, there are components of the Dow Jones 30 Industrials that are now penny stocks, or very near to it. The accepted definition of a penny stock is one trading under $5 per share. A wise investor need take a moment to ponder the long term prospects of an unknown penny stock versus those of General Motors, Citigroup, Bank of America, or Alcoa. Very simply, value investors don't buy penny stocks. They leave them for the speculators.
Is it okay to take a chance on a penny stock once in a while? Of course. Have fun. You never know, it might be the one in five thousand or so that actually works out. But don't build an investment strategy around investing in penny stocks. They're not appropriate for retirement planning, to say the least. If you approach penny stocks with the attitude that you'd probably blow the same amount of money in a casino without breaking a sweat, then you've got the right mindset for the investment.
One last word of caution: never buy a penny stock recommended to you by someone you don't know. You should probably hesitate to buy a penny stock recommended to you by someone you do know, but don't ever buy one on the advice of a stranger. Penny stocks lend themselves too easily to fraud and pump-and-dump schemes. If someone you don't know is telling you to buy a million shares of XYZ because it's about to explode, you can bet he's being paid to do so by someone behind the scenes.