Your pocket guide to investing in penny stocks

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

On the face of it, penny stocks shouldn’t really be that different from their bigger stock market pals. Yes, they’re priced lower than a lot of other shares out there but other than that it’s all pretty much the same, right?

Not quite. Lift the bonnet on those lowly priced shares and you’ll start to see a number of peculiarities that only really pop up at this end of the size scale. So, let’s dive into what makes penny stocks so distinct.

A share that costs less than $5 in the US or £1 in the UK is normally classed as a penny stock. They tend to carry market capitalisations below $300m in the US and £100m in the UK, so you’ll also see the ‘micro cap’ and ‘nano cap’ labels attached to companies in and around this level. Investors in search of the next big world beater are often attracted to this end of the market. There’s no guarantee they’ll find the diamond in the rough but the hope of unearthing a future stock market star is what keeps a lot of investors interested. Combing the micro leagues for winners isn’t without its challenges though, as we’ll see.

Whereas larger listed companies trade on the best-known exchanges like the London Stock Exchange (LSE) and New York Stock Exchange (NYSE), penny stocks usually trade over-the-counter (OTC) or on stock exchanges away from the ‘main market’. It’s not an absolute rule though and you might find tiny stocks on major exchanges, especially if a company’s price initially started high and has dwindled into penny stock territory.

OTC markets and markets designed to offer shares in small and fledgling stocks (think AIM in the UK) often lack the stringent listing standards of bigger exchanges. It means emerging companies aren’t saddled with expensive and often burdensome listing requirements but it also naturally reduces the overall quality of the listed cohort of shares. Did they not want to pay up to meet the main market listing requirements or were they not able to?

It’s becoming easier and easier to access the biggest stock markets out there. The constant buying and selling of the likes of Apple, Amazon and Alphabet means you’re likely to find someone to trade with whenever you like - they’re ‘highly liquid’ in industry speak.

Cast your eye down the market-cap scale and that liquid tends to evaporate somewhat. Lower levels of interest, lower trade volumes and lower values to trade means penny stocks can be relatively illiquid in comparison to large caps. It means trading might be more difficult and could take longer to build up positions or sell out of them. Market makers also make up for the fact that this illiquidity can make it harder to match buyers and sellers by widening bid-ask spreads (the gap between the price to buy and price to sell the same share) to reduce their own risk. If spreads are wide you might already be on the back foot by buying and eyeing up the gap a share would need to make up before you’re even neutral on the trade,

That size effect also means big trades can really move the share prices of these stocks. A single investor’s influence is largely muted in bigger stocks but a trader buying or selling a big chunk of a smaller stock can prompt higher levels of volatility in penny stocks.

It can also be more difficult to find information on penny stocks, as these looser listing requirements mean they don’t have to update the market on their business metrics in the same way that main-market companies do. It can lead to long periods with no real news, making it harder to evaluate near-term company performance.

Common penny stock scams

It’s this propensity for big trades to swing penny stock prices that makes them more susceptible to co-ordinated pump and dump schemes. Groups of bad actors can swell excitement around a penny stock through targeted social media posts, WhatsApp messages, Reddit boards and other communications to encourage the buying of a stock for no other reason than to boost its price in the short term. Having already built up a large holding, they sell at the peak and pull the rug out from under other investors - their sales are usually large enough to trigger a fall, hurting the investments of other individual shareholders. This tends to only really be possible in small stocks, as the manipulated rises would be more difficult to achieve for these groups in large-cap stocks.

Tips for avoiding penny stock scams

• Never make a financial decision based purely on unsolicited ‘hot tips’ or high-pressure instructions to buy or sell stocks.
• Be wary of investment suggestions popping up from unknown sources, on social media or dropping into your inbox.
• If it seems too good to be true, it often is. Ask yourself why someone might be desperate for you to invest rather than just do it themselves if they feel confident.
• Regardless of where an investment idea might come from, always do your own research into a stock. Verify company filings on their website and the stock exchange’s online page.

We’ve talked a lot about the risks of investing in penny stocks (and rightly so, it can be the wild west out there) but, as they say, from tiny acorns do mighty oaks grow. So, how do we tune out the noise and find tomorrow’s growth companies?

The first thing to highlight is how much legwork investors need to do in the micro-cap and nano-cap space. Institutional investors rarely venture this small so research can be hard to come by, with the job made harder by lower reporting requirements from the companies themselves. It means we have to stay up to date on company announcements, CEO appearances, webcasts - anything that offers a view into how the firm is progressing.

In terms of digging into the company financials, profits are great but they can be harder to find in young companies. This can be one reason why a lot of investors choose to avoid the smallest stocks - pre-profit firms can make a lot of people nervous. It’s another sign of the risk involved among the market minnows and another reason why well-rounded research is key. Broader revenue growth and a clear path to profitability can make investors feel more comfortable - sustainable earnings, healthy sales pipelines, recurring revenue models and high gross margins can help offer the message that, while there aren’t any profits now, there hopefully will be soon.

The point is that it shouldn’t be a roll of the dice. Even young and small companies need to evidence quality characteristics to earn a place in your portfolio. You might have to shift your thinking a bit if you’re used to large-cap stocks consistently raking in profits but that doesn’t mean ignoring profitability entirely. The risks are real, especially in untried products and untested management teams so this end of the market requires some serious research and risk management.

• Once you’ve identified a stock you want to buy, it might be helpful to invest small sums of money to begin with. The daily movements can let you see how volatile a journey it can be, especially around earnings, and it’s better to get a feel for it with a small amount on the line.
• Keep strict buy and sell criteria. Penny stocks attract transient traders so company milestones like announcing a big client or losing one can prompt big swings in the price. If you don’t have your own thesis in place you’ll be more prone to reacting emotionally and chasing the price movements.
• Don’t fill the void with nonsense. You will naturally receive fewer corporate updates from penny stocks and the news probably won’t have even heard of them. Try not to use online message boards to replace the silence with unhelpful ramping and deramping of shares.
• These stocks are unlikely to occupy a central role in your portfolio. Good risk management is about sizing positions accordingly so think about how much risk you are adding to your portfolio and where some lowly priced stocks fit in, if at all.
• Get ready for volatility. Risk is one thing but unless you are willing to see large deviations in price regularly, it’s maybe best to start looking up the cap scale.

There’s nothing to say that the next high quality company isn’t already swimming around with the other market minnows - we all have to start somewhere, after all. The danger is that a lot of penny stocks have been around for a long time and haven’t shown an ability to create value for shareholders. It points to a divisive marketplace that seriously needs your attention if you are interested in it. You may have to deal with young company hurdles like licences, permits and the odd strategy setback but try not to compromise on quality - both in terms of the business and the management. The shares will likely be lively enough without the company itself offering up a few surprises. Do your research and manage your risk.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.