Stocks are simply a piece of the pie — a small piece of a corporation. They can be purchased individually from a person who owns the stock or they can be purchased from a market or exchange. In this sense all stocks are the same. Where penny stocks fit in and how they are different from what most people think of as stock is in the level of safety. When evaluating these micro cap stocks there are more red flags to watch for.
Quality of Information
With only so many resources available the Security Exchanges Commission (SEC) can only audit a certain portion of companies every year. While the companies wishing to be on a major exchange pay for their own independent audits as part of being on the exchange, smaller companies do not. In fact corporations smaller than $10 million dollars don’t even have to submit their reports to the SEC at all. Those just over $10 million often don’t get audited because the resources aren’t available and “cooked books” sometimes slip through, remaining unnoticed for years.
The biggest risk of penny stocks is always the dreaded bankruptcy where the stocks become worthless virtually overnight. When the information isn’t trustworthy you lose your ability to see a bankruptcy coming so you may feel like you’ve been blindsided. This greatly increases the risk in investing in penny stocks.
Analysis of Information
If you search any of the major corporations on your favorite search engine you will find thousands of articles written about them. You will also find financial news sites giving up to date information and hundreds of blogs making their interpretation of the news and financial statements.
With this many eyes reviewing the numbers if there is a scheme or huge potential someone will want to be the first to write about it. Dissecting financial information is a difficult task. When a company is very small or unheard of there are few people reviewing the information. With no one writing about, reviewing, critiquing, or inspecting the information it is difficult to determine if claims of a company are true or not.
Listing Standards
The major exchanges require companies to have certain characteristics to prove to investors these are real companies of value. While that doesn’t negate all risk, it proves that the companies have real assets and that they are large enough so they can’t be easily manipulated.
The New York Stock Exchange requires that companies earn at least $10 million per year on average with a positive earnings over the last three years, they must have real cash flow greater than $25 million, be worth at least $750 million or have assets greater than $60 million, plus they need to have enough shares trading so at least 2200 different share holders trade 100,000 shares monthly. These restrictions are put in place so the investor has the ability to both buy and sell their shares in relative real time.
In contrast the OTCBB for microcaps only requires periodic filing with the SEC, and the Pink Sheets don’t even require filing at all. There are no requirements on the size or earnings of the company.
Risk in General
The overarching theme is that penny stocks carry more risk. This risk can come from a few different places. It can come via financial auditing fraud or poor business management directly from the company in which you are investing. It can occur because a small company is crushed by a larger competitor, or the risk can stem from other investors who have enough financial backing to manipulate the stock price. In some cases this manipulation is done through a pump and dump scheme.
The draw with penny stocks is that where there is large risk there is also potential for large reward. The question is do you have what it takes to mitigate enough of the risk and keep enough money in the game to hit those big returns?