Chapter 1

Getting to Know Penny Stocks

IN THIS CHAPTER

Getting to know penny stocks

Separating fact from fiction: The truth about low-priced shares

Penny stocks are shares of companies that trade at low prices - typically anywhere from one cent to five dollars per share. The low-priced shares are usually associated with very small companies that are just getting started. When the companies grow, the value of their shares increases, making money for anyone who owns the stock.

I just described the upside of trading in penny stocks, and it's this potential for making money that explains the growing popularity of this type of investment vehicle. Of course, not all small companies thrive or even stay in business - which brings me to the downside of penny stocks: Should the company shrink, or run into any number of other problems that I describe later in this chapter, shares will decrease in value, leaving investors with a partial or potentially complete loss of their investment.

Many investors are drawn to penny stocks because they find the upside compelling. They're intrigued by the idea of investing in a tiny company in its early stages and watching that money grow along with the company. After all, many companies that started out as penny stocks have gone on to become household names, making their early investors very wealthy in the process. Few other investment vehicles offer the possibility of turning a small amount of cash into a small fortune without even having to work at the company or break a sweat.

To succeed as a penny stock investor, you need to be able to maximize the upside (making money), while minimizing the downside (losing money). Unfortunately, far too many investors treat penny stock trading more like a get-rich-quick scheme (or a trip to the casino) than a legitimate investment strategy. But as I explain in this book, there is a right way to trade penny stocks and a wrong way. Said more directly, there is a profitable way and a costly way. In this book I give you all the information and tools you need to avoid the downside, while benefiting from owning small shares that have the potential to grow exponentially.

The first step to reaping the rewards of penny stock investing is to understand the basics, and the process of gaining that knowledge begins in this chapter. I begin by separating fact from fiction, exposing the truth about penny stocks and letting you know which rumors and innuendos have some basis in reality. (Spoiler alert: A lot of the negative things that you may have heard about penny stocks are actually true.) I also offer a clear definition of penny stocks and fill you in on the ways they're unique investment vehicles.

A Big, Fat, "Tiny" Penny Stock Summary

Companies usually need to raise money to operate, and the most common way to generate that cash is for them to sell shares of their corporation on the stock market. If they need more money at a later time, they can issue even more shares (see Chapter 3 for details on this process). The company gets money to operate; in exchange, the new shareholders get part of the company.

The shareholders will see the value of their investment in the company change based on what the share price does. If the company does well and grows, the shares typically increase in value. But if the business shrinks or runs into detrimental issues such as weak sales numbers, lawsuits, or new competitors, its shares will likely decrease in value.

Although the aim for most companies is to get bigger and bigger, the majority of them start out very small, with only a handful of employees or a total company value of a couple million dollars or less. Their shares may trade for a few dollars, or even pennies. However, those penny stocks may become worth much more if the companies grow. If everything goes according to plan, the stock won't actually be a "penny" stock for long, and both the value of the shares and your investment in them will be dramatically higher.

A lot of quality companies trade as penny stocks and many of these will perform very well for their investors. Of course, because share price is a reflection of perceived value, many downright awful companies with no prospects, or even on the verge of bankruptcy, trade as penny stocks as well.

Unfortunately, the number of low-quality companies outweighs the good ones. In fact, only 5 percent of penny stocks I review pass my analysis. Combined with the propensity for promoters and shady characters to provide misleading information (more on the shadowy side in a bit), penny stocks have earned a bad name.

Some of the negative connotations surrounding penny stocks suggest that they are

• Hard to buy and sell. This is true for lightly traded shares on many of the penny stock markets. You won't have this problem if you stick to shares trading on the better stock exchanges, which I detail in Chapter 3.
• Subject to scams. Unfortunately, penny stocks are the focus of many scam artists because of the opportunity to make money by manipulating the prices of the underlying shares. Dishonest promoters try to push up the prices of the penny stocks they own by tricking unsuspecting investors through free newsletters and message boards.
• Based on low-quality companies. The majority of penny stock companies are not strong - and that's putting it kindly. The key is to avoid those lackluster stocks and instead find the top 5 percent that will be extremely profitable. This book details how you can do exactly that.
• Volatile. Penny stocks are volatile, but that's part of their appeal. Although such volatility isn't appropriate for everyone, low-priced shares can move quickly and significantly, which can generate profit potential that isn't available elsewhere.

You need to be aware of the risks surrounding penny stocks. That awareness, combined with appropriate knowledge, will enable you to sidestep the dangers, while remaining open to all the opportunities that low-priced shares can provide.

Defining Penny Stocks

No universally accepted definition of the term penny stock exists. Instead, folks in the financial sector categorize these low-priced shares in a variety of ways, depending on who is doing the defining and why. What one trader may consider a penny stock may not qualify as such under another person's definition.

In the following sections, I walk you through the three major ways investors typically distinguish penny stocks from their more expensive counterparts.

Price per share

Price per share is the most common (and simplest) criteria for identifying penny stocks. Many people apply the tag to any shares trading at one dollar or less. For others, the price range includes stocks trading as high as three or even five dollars per share.

The closest definition to actually being "official" is that of the Securities and Exchange Commission (SEC), which identifies shares trading at five dollars or less as a penny stock. Following the SEC's lead, almost all stockbrokers and professional investors have adopted the same criteria, and I have as well. So, for the purposes of this book, I consider penny stocks to be any shares that trade at five dollars or less.

The primary drawback with using this definition is that price fluctuations can move the stock below and above the threshold level. What started out as a penny stock in the morning could trade above the threshold price at noon and then fall back below it an hour later.

Market capitalization

Market capitalization (market cap, for short), refers to the total value of a company, which is derived by multiplying the total number of shares available by the price per share. For example, if a company has two million shares valued at two dollars each, the market cap of the company is four million dollars. Some investors like to consider companies with market caps of less than $10 million to be penny stocks, while others use a cutoff point of $25 million, or $100 million, or an even greater number.

Using market capitalization to define penny stocks is more involved than simply looking at the price per share. Also, because the underlying share prices and the total market cap continually change, it can make for more work when identifying penny stocks. Using market cap may also lead to situations in which a company trading at one cent per share isn't considered a penny stock (due to the company having an extraordinarily large number of shares outstanding).

Most investors don't use market capitalization as a method to define penny stocks. However, some prefer to focus their holdings on companies of a certain size for the implied stability that comes with larger businesses, and in such a case they may find the market capitalization approach helpful.

Stock market

Some choose to label all companies trading on lower-quality stock markets (see Chapter 3 for details) with the penny stock moniker. For example, any company listed on the Pink Sheets may be considered a penny stock, even if its shares are trading at $90 each and its market cap is in the billions.

Mix and match

In some cases, investors may combine more than one of the previous criteria when defining a penny stock. For example, they may decide that any company trading on the Pink Sheets and with a share price of less...