Penny Stocks. Invest? Or Not Invest?

Today I would like to respond to a question I had awhile back about investing in penny stocks.

Comment:

Clay, Great stuff... a lot of good information! Let us know your thoughts on the so called "penny stocks" With the market going to way it is going is it advisable to venture that way? or stick to the bigger stocks?

First off in I would like to say in a market like this a lot of companies have been put into the penny stock category. A penny stock is considered any company that trades for under $5.00 a share. Penny stocks in my opinion are very speculative, volatile, but rewarding at the same time. Should you invest in them? Of course you should. Everyone should make room for at least one speculative company in their investment portfolio excluding retirement money and those nearing retirement. Those who are late in the game cannot afford to lose any money. Penny stocks or stocks speculative in nature should be less than 20% of your portfolio. This is only to reduce your risk and keep you from losing all your money in case your speculative play doesn’t work out.

Penny stocks have the potential for huge upside profits and if nothing else it’s a great way to keep you motivated with stocks. Penny stocks keep you on your toes and are extremely fun to watch when the price moves in the right direction. Not all penny stocks are considered equal. There is usually a good reason why a company trades below $5.00. When investing in a penny stock doing your research to find out that reason is key.

Some stocks are put there because people panic and worry that the outlook of the company is grim and many flee out of fear. One stock that comes to mind is Ford (F). Ford from Sep of 2008 into the end of April of 2009 traded below $5.00. Many were worried that the automotive industry would never turn around. GM was struggling and on the verge of bankruptcy, cars weren’t selling and many thought Ford would follow GM's footsteps. There was no reason to own Ford and therefore the stock price fell to levels way past belief. If you would have spotted the potential of the economy turning itself around and buying Ford at that time you would have made a small fortune. (Current Price $10.62 a share)  That's over a 900% GAIN since the Nov 17th 2008 low of a $1.01 a share. This is a great example of a penny stock winner.

On the negative some stocks go down into penny stock territory and never come back. A great example of this is Lehman Brothers (LEH) this was a big head liner when the stock market began to crash in 2008 as the financial market began to tighten, banks were losing money on defaults of loans, and one of the biggest financial institutions that didn’t make it was Lehman Brothers. This by far was one of the biggest losses the stock market had to bear. People were in disbelief that a great company like Lehman Brothers was in so much trouble that it had no choice, but to close up shop and file for bankruptcy. The bad/misleading thing is that still to this day Lehman trades on OTC (Over The Counter Market). This is highly unregulated and Lehman continues to trade because brokers continue to make commissions off this company even though it's virtually worthless. This is an example of one stock that will never come back. This is very unfortunate, but this can happen to even the best of companies.

Some people think that investing in penny stocks is a sure fire way to make money. I explained in detail that this isn’t the case for all penny stocks. People think their cheap and would rather buy thousands of shares of a penny stock than to buy 10 shares a good quality company. I would say you have a better chance of keeping your money by investing in the good quality stock, but there is nothing wrong with a speculative play along side a portfolio of good quality stocks. You never know that speculative stock could be the next Apple!

Here’s the thing with penny stocks. Penny stocks go up on large volume. There needs to be a good reason for volume to increase drastically since many fund managers aren’t allowed to touch penny stocks. A great penny stock will have a story that is very enticing. A company may have a new gadget or product that has the potential to be huge. Many drug companies trade at low prices for the potential of a new up and coming drug that could get FDA approval. Penny stocks are driven by positive news. If the volume is stagnant and there is no near term catalyst to move the stock you could end up sitting on your stock for years. Holding onto a loser is not fun and is highly advisable that you dump your stock if the reason you invested your money changes to the negative. Also, if you happen to come across a penny stock newsletter or a pamphlet in the mail please beware that most likely this is a scam to increase the volume of stock to allow for a few people to sell their shares while you lose money. It's called pumping and dumping!

The downfall is penny stocks are volatile in price and can drive a person to panic and sell for a loss. Many will end up going to zero, but the potential to find those hidden gems is still worth looking for as long as you invest a small portion of your money. A good strategy for investing in penny stocks would be to allocate your speculative money over a basket of penny stocks (5-10) this way you can spread your money around and diversify just like you would with any other investment. You will have a few that go to zero, maybe some that don’t move at all, but your odds of finding that potential moneymaker is definitely better than betting on one single stock. Diversification allows you to preserve your capital and continue the fight if some of your stocks happen to flat line.

So yes it’s okay to invest in penny stocks, but be prepared for volatility and the chance to lose your entire investment. On the positive as I said earlier you could stumble upon the next Apple! I have had my fair share of winners and losers in the penny stock territory and continue to believe that money can and will be made investing a small portion of your portfolio in penny stocks. One good penny stock to watch is Citigroup (C). Citigroup trades under $4.00 at the moment and is being held down by the continuous selling of shares by the government. Once the volume lets up I see this stock moving higher. It's a great turnaround story and my buddy/investment guru Jim Cramer has the same opinion. Thanks Jim Cramer for the heads up on Citigroup!

Happy Trading!

Thank You,

Clay-

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