Value investors are constantly on the lookout for underpriced financial assets that could be parlayed into something of much greater value in the future. Although hindsight is always 20/20, it’s extremely difficult to predict which low-priced stock will become the next Microsoft or Apple. Penny stocks – shares that can be traded for under $5 – provide one opportunity for investors to potentially strike it big. However, as we will demonstrate below, the speculative nature of penny stocks may make them more risky than conventional stocks and other financial assets.
Despite the conventional name, penny stocks are often misunderstood by investors, as there is no generally accepted definition of what they are. Confusion about company size, market capitalization and exchange listing have led to competing views about what actually constitutes a penny stock. As a general guideline, we consider a penny stock to be any company that trades for under $5.
Although penny stocks look attractive because of their price, they are considered highly speculative. In most cases, investors have no basis to consider a penny stock to be a good investment. Penny stocks are typically very small companies with small capitalization, low liquidity and limited regulatory standards. A typical penny stock simply doesn’t pass the litmus test of value investing pioneered by the great Benjamin Graham.
Despite their speculative downside, penny stocks can still be leveraged by savvy investors who have already diversified their portfolios. Even Benjamin Graham permitted some room for “good speculation,” provided it doesn’t form the basis of your trading strategy. Because penny stocks don’t cost much, they may be suitable speculative picks in the right circumstance.
If you’ve decided to dabble in penny stocks, there are a few things you might want to keep in mind:
- You should consider companies you actually believe might succeed. Conduct fundamental analysis as you would with any other stock; look at the company’s assets, liabilities, revenue and expenses.
- Use a free stock screener to filter penny stocks based on intrinsic value, earnings, dividends and cash flows.
- Disregard tips, newsletters and forecasts – after all, they are speculative in nature and are often provided by penny stock promoters.
- Prepare to have a much quicker turnaround than other assets in your portfolio.
- It goes without saying that you trading large positions are very risky, regardless of how well you believe the penny stock will perform.
- If you’re not a technical trader, consider becoming one. When dealing with highly volatile penny stocks, charting software that allows you to measure support and resistance levels is extremely important.
While there is no way of guaranteeing your success in this market, understanding the risks of penny stocks and diversifying your investment portfolio accordingly are wise words indeed.
 Benjamin Graham (1949). The Intelligent Investor. Harper & Brothers.