Penny Stocks: The Worst Investment You Can Make

by Alexander Green, Oxford Club Investment Director

Due to the magnitude of the recent bear market, we’ve been able to buy a lot of fine companies for less than $10 a share. Many of them are already trading considerably higher.

Yet some readers want us to go all the way down to the cellar. “Why don’t you ever recommend penny stocks?” one subscriber asked. “After all, it’s easier for a 50 cent stock to go to $1 than for a $50 stock to go to $100.”

For starters, it’s not.

Over the years, dozens of studies have shown that lower priced stocks don’t do better than higher priced stocks. In fact, they do considerably worse.

Ironically, while it’s not easy for a 50 cent stock to go to $1, history shows that going from 50 cents to zero is like falling off a log.

Reasons Why Penny Stocks Stink

There are other reasons I won’t touch penny stocks with a barge pole:

• For starters, the vast majority of tiny, unprofitable companies are such ridiculous long shots they don’t even merit your attention. Most of these companies have little if anything in the way of profits, not to mention the first prerequisite: sales.
• Secondly, you could drive a cement mixer through the bid/ask spread on many of these shares. If a stock is offered at 30 cents and bid at 24 cents, for instance, you’re down 20% as soon as you get your trade confirmation. (And that’s before commissions.)
• Thirdly, penny stocks are thinly traded and easily manipulated. You may buy a penny stock and see it zip higher. But then try getting out. It’s pretty disheartening to know you can drive down the price of your stock simply by selling a couple thousand shares at market.

And then there are the outright scammers…

Penny Stock Scams & Penny Stock Promoters

Often referred to as a “pump and dump,” a penny stock scam is when the insiders talk the stock up on one hand while bailing out like there’s no tomorrow on the other. That’s usually because despite the great story – and make no mistake, the stories are always fabulous – the company’s genuine business prospects are usually nil.

But penny stock promoters want you to trust them, to believe in the hot tip.

If you’re going to evaluate a penny stock, here’s how the penny stock promoters would like you to do it:

• By recognizing the multi-billion dollar market they intend to operate in.
• By considering the enormous profits they’ll generate when their technology is finally commercialized.
• By noting the proven reserves of the mining company operating next door.
• By the preliminary results of their Phase I trials.
• By any criterion you can think of except what the company is actually earning… Because that figure is virtually always zero.

A Few Basic Penny Stock Precautions

If you insist on discovering these lessons for yourself, if you doubt my words, or for some reason are drawn to penny stocks like a moth to a flame, at least take a few basic precautions.

Start by reading the company’s most recent quarterly or annual report…

• Does it have sales or earnings?
• What kind of debt is it carrying?
• How long has the company been in business?
• Who are the people behind it?
• What is their track record?
• What is their rap sheet?

In other words, if you’re going to roll the dice, make sure it’s a genuine speculation, not just a mindless crapshoot.

Also, take a look at what the insiders are doing. If the insiders – the ones who seem unable to contain their enthusiasm for the company’s near-term prospects – are dumping the stock en masse, you know all you need to know.

Run.

Some will say I’m unduly pessimistic. (Penny stock promoters, especially.) And, clearly, a few successful companies did start out as penny stocks.

But for every success story there are hundreds of penny stocks whose charts bear an uncanny resemblance to the last flight of the Hindenburg.

In short, there are plenty of smart ways to invest your money. Toying with penny stocks, in my view, is one of the dumbest.

Good investing,

Alexander Green

P.S. My New Frontier Trader service is designed to capitalize on the incredible opportunities presenting themselves in emerging markets today. We’re seeing younger “American equivalents” of Microsoft, IBM, Google and other giants – in their infancy. Find out more about Alex’s New Frontier Trader.

Today’s Investment U Crib Sheet

Many of the analysts we talk to are starting to get a little more than concerned for the current rally and the possibility of a pullback. It would mean that we’re in a bear market rally, which is little more than a “head fake” for investors and traders. And it would mean that you might not even need penny stocks to put your assets at risk.

Consider the prices of oil and gold. Gold is at $873 an ounce, while oil is sitting around $50 a barrel. They seem remarkably calm for a charging bull market.

The fact of the matter is that as cautious investors, we need to prepare for the worst, even as we hope for the best. It’s a sentiment echoed by our own David Fessler yesterday – that we need to “Be Wary of Bank Stocks as the Other Shoe Drops.”

And earlier last week, Lou Basenese discussed a new way to hedge to value of your home should the value continue to drop. “How to Buy & Sell a Home on the NYSE“.

There is a saying about the proverbial “Wall of Worry” – the longer it lasts, the greater the likelihood that it’s real. With very few people discussing the possibility of a pullback, the better the chances are that we’ll see one.

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