What are penny stocks?
What are Penny Stocks? Penny stocks are the red-haired stepchild of our capital markets: badly behaved, often unpredictable, and generally despised by securities regulators. They’re beloved by many traders, though, because their volatility and attractive pricing can, if the circumstances are right, make for large profits on small investments.
In the Securities Exchange Act of 1934, the SEC defined penny stocks as any equity security not listed on a national exchange that trades below $5. More recently—perhaps taking into account the carnage that followed the economic meltdown of 2008—the agency has revised its definition, noting that “while penny stocks are generally quoted over-the-counter… they may also trade on securities exchanges, including foreign securities exchanges.”
For practical purposes, most people think of pennies as low-priced stocks that trade on the OTCMarkets platform. OTCMarkets ranks its issuers in tiers, depending on the amount of disclosure they offer to investors and the general public. At the top of the heap are companies that file periodic financial reports with the SEC; at the bottom, moribund issuers that have no business and share no information with anyone, not even OTCMarkets. There are two broad groups: SEC filers—sometimes referred to as OTCBB companies because they once traded on FINRA’s Over-the-Counter Bulletin Board—and Pink Sheet companies, so called because before the advent of the internet quotes for them were printed on pink paper and circulated by hand.
Not all OTCMarkets stocks are the kind of pennies that appeal to brokers. Some are ADRs (American Depository Receipts) issued by large and successful foreign companies. Others are stock in companies—mostly regional banks—that have no real interest in trading actively. Both can be quite expensive, and are not the subject of this article.
A brief history
Not so long ago, nearly all penny stocks actually traded for pennies, and not often over a dollar. They generally had only a few million shares outstanding, and low floats. They were hard to trade, because electronic quotes weren’t available until the mid-’90s; quotes and other information about them didn’t appear in mainstream financial publications, either. There was no electronic trading platform; everything had to be done by telephone. Trading pennies wasn’t an attractive, or even feasible, proposition for most people.
The rise of the internet, and the appearance of discount brokerages that allowed clients to trade electronically changed all that. Best of all were the cheap commissions: $9.99 a trade, rather than hundreds of dollars. A good economy—until the dotcom crash—brought new investors to the markets, many of them not looking to buy mutual funds or blue chips.
The nature of penny stocks changed with the new market for them. Around 2000, Tony Cataldo, CEO of Miracle Entertainment, invented superdilution. For Cataldo, much more was much better. He issued billions upon billions of shares of MEMI, taking the stock price down to $0.0001, an unheard of level. When buying dried up, he did a reverse split and began the process all over again. Astonishingly, people still bought, and so a trend was established. As another CEO notoriously proclaimed a few years later: “Dilution is the solution!”
While these diluters were doomed in the long term, most players weren’t thinking of that. Though some were, or believed themselves to be, investors, others bought simply for the thrill and the hope of a quick gain. Sometimes their hopes were realized.
But nothing lasts forever. Nowadays there are many fewer superdiluters. Though some companies still choose to issue billions of shares, and others are forced to do so thanks to toxic financing arrangements, the majority have scaled back. This is due in part to more aggressive interest in the issuance of unregistered shares on the part of the SEC, FINRA (Financial Industry Regulatory Authority), and DTCC (Depository Trust & Clearing Corporation).
More expensive penny stocks are once again in favor. But compared to most exchange-listed issues, they’re still cheap.
The good and the bad
Many retail traders feel pennies give them optimal bang for their buck. For quite a few, the choice between buying one share of Apple at $400 and 8000 shares of a Pink trading at $0.05 is a no-brainer. These stocks can and do often enjoy tremendous runs.
Financial message boards are full of talk of penny stock millionaires, Maseratis and parties in Vegas. In reality, all that is largely a fantasy. As with anything else, successful trading requires knowledge, experience, and an understanding of the risks involved.
The SEC warns about these risks: a lack of transparency, illiquidity, possible fraud, and much more. Pennies also tend to be promoted, and the biggest runners often use the most disreputable touts. Anyone thinking of joining in the fun needs to learn how to research stocks thoroughly, and then needs to figure out how to trade them. Anyone who fails to do either is likely to end up without a chair when the music stops.
In addition to the risks the SEC outlines, there’s an increasing danger of regulatory action. In the last couple of years, the SEC, FINRA, and DTCC have ramped up their efforts to contain microcap fraud. The result has been an increased number of SEC suspensions and lawsuits, and DTCC chills and global locks. SEC suspensions send its subjects to the Grey Market, whence almost none return. Delisting to the Greys is a death sentence. Chills affect clearing and settlement, making profitable trading difficult. Global locks are designed to stop trading altogether.
Penny stocks can be excellent trading vehicles, offering the possibility of profits far exceeding those generated by the majority of exchange-listed issues. But they are not investments. They can crash and burn as quickly as they rise. Cautious players make sure to familiarize themselves with the history of the company in question, and they cash in their winnings as opportunity permits.
Nobody ever went broke taking a profit.