The temptation -- and the danger -- that comes with trading in penny stocks, generally described as stocks that trade for less than $5 a share, is that much greater in a turbulent economy when people have less money to invest.
Pick the right one, and the bang for the buck is quite good. But the wrong one could be a bust or even a scam.
"Penny stocks are becoming much more popular not just in spite of the economic weakness, but because of it," said Peter Leeds, author of "Invest in Penny Stocks" and CEO of PennyStocks.com in Toronto.
"With less money to invest, people have fewer options, and they are more desperate for returns. They find penny stocks may be a way to make something out of a small investment."
The math certainly looks good to discount hunters looking for a find.
- Ninety-five percent of penny stocks on the market are bad investments.
- Never buy pink sheet companies or trade a penny stock recommended from free newsletters, faxes, emails or message boards.
- Find out why a stock is trading for pennies a share. Is it simply overlooked and undiscovered? Or are there other reasons?
- Invest in penny stocks with only the money you can afford to lose in a worst-case scenario.
Source: "Invest in Penny Stocks" by Peter Leeds
Someone with only a couple of hundred dollars to invest could barely afford one share of IBM stock, which currently trades for about $160 a share. But that same investor could afford about 1,200 shares of Wizzard Software Corp., (WZE) a publicly traded software products company on Baum Boulevard, with a stock price of about 17 cents a share.
Even a 1-cent increase in the share price of Wizzard represents a nearly 6 percent profit for the investor, whereas IBM's share price would have to reach $170 for a similar 6 percent return.
"Logically, penny stocks would have a bigger percentage move," Mr. Leeds said. "You could make a lot more with your money than you can with bigger stocks."
The lure of buying low-priced shares that could rapidly double or triple in value is offset by the risk of losing 100 percent of the investment. In addition to the possibility of penny stock scams, more than a few of these financially weak companies go bankrupt.
Most traditional advisers, such as BPU Investment Management, Downtown, have a policy against recommending penny stocks to their clients.
"We will execute transactions for a client who is a principal shareholder of a penny stock company," said Paul Brahim, managing director at BPU. "But as a firm, we strongly advise clients against owning them.
"This is also the land of scams. Penny stocks are high risk, and they are notorious for pump-and-dump schemes."
In such schemes, penny stocks are manipulated and promoted by people who are paid by penny stock companies. It's not uncommon for inexperienced investors to get burned in this arena.
According to Mr. Leeds, finding the 5 percent of penny stocks worth investing in requires careful research. Investors must look at a company's balance sheet to make sure its assets are in line with its liabilities and examine its income statement to be sure the company is fundamentally solid. Investors also would want to look at trends in the company's performance, consider its outlook in the industry, its competition, its management team and technical analysis.
This kind of investing is definitely not for everyone. But for those with a high tolerance for risk and money they can afford to lose, there is always a chance of hitting the jackpot.
"Penny stocks are exciting because of the opportunities involved," said Jonas Elmerraji, a penny stock specialist at Agora Financial in Baltimore. "They are either less mature companies or they are established companies with a smaller share of the market.
"So, their growth potential is much greater than a blue chip stock. That's the real draw."
Compared to about 500 stocks that major institutional investors would be interested in, there are thousands of penny stocks trading on major stock exchanges, the over-the-counter market and the unregulated Pink Sheets.
Mr. Elmerraji uses a much broader definition for penny stocks. He tracks companies with a market capitalization of around $2 billion or less.
"The trading characteristics for stocks trading for pennies or for $15 to $20 are not all that different," he said, adding that the penny stocks he recommends are generally priced between $1 and $15.
Some examples of penny stock companies he would likely recommend would be Jet Blue (JBLU), trading at $4 a share, or Tesla Motors (TSLA), trading at $21.90 a share with a market capitalization of $2.28 billion.
When it comes to any type of stock market investing, Mr. Elmerraji said investors should not get too caught up in share price.
He said a company could make its stock price whatever it wants by shifting the amount of outstanding shares, through either stock splits or reverse stock splits. What the company cannot change is its market capitalization, which is the value based on the number of outstanding shares multiplied by the share price.
"Penny stocks are more volatile and have greater growth potential," Mr. Elmerraji said. "Their percentage return should be larger if you do your homework. There's a lot of junk out there.
"You are more likely to run into scams in the penny stock world, which has given them a bad name."
Tim Grant: firstname.lastname@example.org or 412-263-1591.