Beware of Penny Stocks
Several years ago we wrote about how to invest in penny stocks. The common rationale for investing in penny stocks is that they are cheap. It is the mistaken belief of naive investors that these stocks have nowhere to go but up.
For the beginning investor with a small amount of capital penny stocks can seem attractive. They wonder how to invest in penny stocks. Before looking at how to invest in penny stocks let’s see what we are talking about. These are stocks that typically sell for less than $5 a share ($1 by some definitions) and, thus, allow the investor to buy a block of shares for less than if buying 3M for $86.20 a share of Google for $595.47 a share. Penny stocks are often companies that are starting up and have a net worth in the millions instead of billions. Because few if any stock analysts follow penny stocks they can be sleepers with a large degree of hidden value. How to invest in stocks, in general, is to know the fundamentals of the stock. This can be difficult with penny stocks. Thus penny stocks can be traps into which the unsuspecting investor might fall.
Beware of penny stocks. If you have unique insight into the company you may know something that stock analysts do not. This can be very profitable. If you do not have any special insight into the stock you may be in for a rude awakening when the stock that sold for pennies now is out of business. We are not the only ones to advise investors to beware of penny stocks.
Price per Share versus P/E Ratio
USA Today writes about penny stocks.
Beginning investors are often attracted to penny stocks thinking the low per-share price means they’re cheap. But this thinking is misguided. Keep in mind the per-share price by itself doesn’t tell you much about a stock. It’s the per-share price compared with the company’s profit, revenue or cash flow that tells you if the stock is actually cheap or not. Some penny stocks could be the most overvalued stocks you can buy — if the company’s profits are evaporating, the company loses money or has poor prospects. Penny stocks are also prime targets for scammers. Their low per-share prices make them easy targets to be manipulated. They are also at risk of being delisted from the exchanges. Most online brokers allow you to buy penny stocks, but most charge added surcharges. Only 15 stocks in the Russell 3000 trade for less than $1 a share. Avoid those.
Share price compared to profit is the price to earnings ratio (P/E ratio). A high P/E ratio indicates that the stock is expensive and a low P/E ratio indicates that it is cheap. In our recent article about the risk of higher interest rates we note that blue chip stocks are being bid up and more risky stocks, such as penny stocks, are being bid down as investors flee to quality. Beware of penny stocks at a time when interest rates and thus the cost of doing business are going to go up and putting pressure on weak companies. Always remember that there is a reason why a stock sells for pennies and that reason may simply be that the stock shows very little promise of long term success.