Deciding What Stocks to Buy? Avoid Penny Stocks

Penny stocks, while they don’t necessarily trade for mere pennies, are stocks that trade for a low share price — and they’re risky bets most investors should avoid.

youngInvestorsB.png Deciding What Stocks to Buy? Avoid Penny StocksAccording to the Securities and Exchange Commission, the price ceiling for “penny stocks” actually is $5 per share, although that definition varies by source.

While penny stocks might sound like an appealing proposition to young investors who don’t have the cash to shell out hundreds of dollars for a single share of high-priced blue chips like Google (GOOG), they’re not — there are much better places to put your money than in penny stocks.

Most penny stocks are microcaps, meaning they have a market capitalization (share price times the number of outstanding shares) less than $300 million. Penny stocks also aren’t usually traded on a major exchange like the New York Stock Exchange or Nasdaq, but are instead traded “over-the-counter” or on the pink sheets.

While penny stocks (and microcaps) are attractive to some investors because of the big profit potential, they also are risky bets. Penny stocks usually are thinly traded and thus illiquid, meaning it can be difficult to sell shares once you own them. And according to the SEC, it can be difficult to accurately price penny stocks.

Plus, penny stocks are a playground for crooks. These thieves prey on investors in the following ways:

False promises: Fluffy marketing about your product is one thing, but faking contracts or alluding to pending deals that never will transpire are another. Typically, these companies have products that will “revolutionize” an industry or have growth potential that makes them “the next Apple (AAPL).” Take everything you read with a fistful of salt in the market in general — especially when it comes to penny stocks and microcaps.

Celebrity spokesmen: Penny stocks aren’t above paying someone to tout their company. Daniel “Rudy” Ruettiger of Notre Dame walk-on fame was convicted of fraud for his antics in a tiny sports drink company, creatively called Rudy Nutrition. Rapper 50 Cent was paid to talk up a penny stock on Twitter. Clearly, this is a big warning sign.

Pump-and Dumpers: The previous two penny stock scams feed into this third: unscrupulous investors who try to inflate a microcap’s price so they can abandon ship at the top and make a fortune — while others ride it down to oblivion. This is most easily achieved in microcaps with thin volume, since it’s easy to move the market with a stock that trades only a few thousand shares a day. Of course, it’s not like regulators are blind to these schemes. The Financial Industry Regulatory Authority issued a scam warning concerning some marijuana stocks, writing:

2014 STOCK BLACKLIST: Any one of these widely-held stocks could wipe out all of your profits. Download this free "sell list" and see if you own any of these ticking time bombs. Click here — yours FREE!

“The con artists behind marijuana stock scams may try to entice investors with optimistic and potentially false and misleading information that in turn creates unwarranted demand for shares of small, thinly traded companies that often have little or no history of financial success. The scammers behind these ‘pump and dump’ scams can then sell off their shares, leaving investors with worthless stock.”

It’s good to be aware of such warnings , because for every cockroach you see, there are dozens more hiding in the walls.

So how do you protect yourself from scams, such as those penetrating the ranks of some marijuana stocks?

The simplest way is to never trade microcaps or penny stocks. I have written extensively on the topic (see this post about microcaps, this post about low volume and this post about penny stock risks), and many in financial media agree with me.

Stick with stocks that trade more than 100,000 shares daily, have a market cap of more than $500 million and trade on major exchanges. There are a few exceptions to this rule, but it’s better to be safe than sorry … and penny stocks are anything but safe.