Who: This post is for people looking to invest in penny stocks or those who have considered it in the past or are considering it now.
What: This post will discuss some important information about penny stocks.

J.D. Roth, author of the blog “Get Rich Slowly” graciously offered me the opportunity to post a guest article last week. Here is my article, entitled “The Beauty of Penny Stocks,” with some minor modifications based on some comments and discussion on the site.

The beauty of penny stocks is that they are one of the only investments for which one simple, blanket rule applies: There is rarely ever a good reason to buy a penny stock.

Why not?

Penny stocks cost very little for a reason.

The efficient market hypothesis states that the stock price generally reflects all available knowledge about that security. In other words, a $2.00 stock is worth $2.00 to most people — no more, no less. The weak form of the hypothesis states that it is possible to find undervalued companies. In my experience, many people invest in what they believe to be undervalued companies when in actuality, the companies are in fact fairly priced.

If there were solid data or a concrete reason for the stock to be valued at a higher price, it would already be at that price. It is incorrect to think that you are getting a bargain when you purchase a penny stock. If you purchase a penny stock, more often than not, you are gambling — you are not investing.

Penny stocks are not cheap.

When investing, it is important to know how to value a stock. This concept is the topic of hundreds and hundreds of investment books. It is entirely possible that a stock trading for $72 is cheaper than a stock selling for $8. The price of a stock does not determine whether or not a stock is expensive. There are many other metrics for that.

My favorite (and easiest to understand) metric is the Price Earnings (P/E) ratio. The P/E ratio, roughly speaking, is a ratio which relates the price of the stock to the earnings that one can expect to receive from the share of the stock. This ratio lets you compute how expensive a stock is. The higher the P/E ratio, the more “expensive” a stock is. There are many documented problems with a P/E ratio, but I find that for basic analysis it is a good way to compare the relative value of very similar companies.

When you compare the P/E ratio of penny stocks to solid stocks, you will notice that the P/E ratios for most penny stocks are much higher. This is because penny stocks often have very few earnings, and their value (what little value there is) is derived from expectations of future earning (beyond the scope of the P/E ratio). Because the company has a very low (or negative) P/E ratio, you know that the company isn’t making much money yet.

Making a profit is not easy.

A large number of businesses fail before the completion of five years of operations. Investing in a new company with no proven track record is very, very risky. Roughly speaking, if you expect a total loss of your investment 95% of the time, a two-fold increase in your investment 4% of the time, and a ten-fold increase in your investment 1% of the time, the expected value of your $1000 gamble is -$820 ($180 left).

($1000 * 95% * 0) + ($1000 * 4% * 2) + ($1000 * 1% * 10) = $180

Even this scenario is wildly optimistic since the chances of the stock being so successful (10x growth) is much less than 1%. With penny stocks, you’re risking failure a most of the time. Sure, you might get a huge return if the company goes big. But I contend that you can get similar returns over time by investing in well-picked, small-mid sized companies with a proven track record of earnings!

Penny stock prices are easily manipulated.

Since penny stocks have such low market capitalization (low share price and/or very few outstanding shares), people can easily manipulate their stock price by putting in large buy or sell orders.

A common tactic used by many scam artists is a “pump and dump”. The scamsters buy many shares of the stock at a low price and then pump up the stock. They spam investors (via fax or via e-mail), claiming that they have a “hot new stock.” The stock is artificially hyped by the scamsters who own shares. Even if a only a few people believe the hype, they will purchase enough stock to push up the stock price. As soon as there is a large purchase, the scamsters will sell all their shares, which will send the stock price plummeting. This leaves the scamsters with the profit and the scam-ees with depreciated shares of a useless company.

If you’re going to gamble, get better odds.

Honestly, if you are looking for a quick way to double your money, my suggestion is to take all the money you’d put into penny stocks, head to the nearest casino, and play a hand of Blackjack with favorable rules. The expected value of your $1000 gamble is close to -$10 as opposed to -$820!

Final Verdict: F+
Note: This verdict reflects a highly complex algorithm which determines how awesome a financial product is. This is not limited to equity products.

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