risk and perceived lack of safety associated with penny stocks are what create the opportunities for penny stock investors to reap substantial rewards. If the underlying companies were not in a financially precarious state, penny stocks wouldn’t trade as penny stocks at all, but would instead be priced at much higher levels.
Investors who can identify and accept areas of concern for a company, or anticipate improvements in those risk factors, can find numerous values among low-priced shares.
❯❯ Accept the risk. As long as you’re aware of the greater perceived risk and are willing to accept it in exchange for the potential of greater returns, you can find opportunities among penny stocks.
❯❯ Find overblown risk perceptions. When investors are overreacting to a company’s risk factors, they may greatly undervalue the shares. Investors who recognize that the concerns are overblown can accumulate shares at very low prices. For example, if a drug development company with 12 products fails to get FDA approval for one of them, the shares often collapse in response. But investors who remember that the company has another 11 drugs in development will scoop up the shares for a fraction of what they’re actually worth.
❯❯ Identify shrinking degrees of risk. Often the risk factors keeping the shares of a company down eventually abate or change for the better. Usually there is a delay of weeks or months between when circumstances improve for the company and the resulting share price increases. That delay represents an opportunity for people to invest in a penny stock that’s being held down by perceived risk that’s no longer a factor.
Investor following and visibility
Larger companies generally trade on bigger stock exchanges (I tell you all about stock exchanges in Chapter 3). Those companies have more investors, a greater number of people following their shares, and larger amounts invested in them.
When a massive company trading on the New York Stock Exchange needs to raise money, it generally doesn’t have a problem getting that cash. Given its high level of visibility among investors and its large following of institutional investors and analysts, it is able to generate the funds it requires.
Penny stock companies, on the other hand, have far fewer involved parties and are usually listed on lower-quality stock exchanges with easier listing requirements and fewer serious investors. When they need to raise money, they often have to sell their concept first. They need to convince individuals, banks, and other creditors that they represent a good investment. Part of the job of a tiny company – and a potential distraction to operations – invariably becomes generating investor interest and expanding its base of shareholders. Insiders and key executives often front a major portion of any money a penny stock company needs; they know the potential the business holds, but the company doesn’t have enough of a following or history of operations to generate the money from a bank or outside investors.
Any penny stock has the responsibility to increase the visibility of its shares and its company. As it becomes more successful at this task, whether by listing on a more widely followed stock market or expanding the number of shareholders who are invested in it, the company may find that the price of its shares increases, perhaps even to the point where it no longer qualifies as a penny stock.
Larger stones take more force to move
The bigger something is, the more effort it will require to move or lift. This is not only true in the physical world, but in the stock market as well.
Multibillion-dollar corporations might encounter issues that they barely even notice, while those same events could derail or dramatically impact any micro cap company. While small events don’t tend to affect the prospects or direction of a blue-chip stock, everything matters when a company is new, tiny, or more vulnerable.
Larger corporations are also more diversified. They may have several business lines, thousands of customers, offices in dozens of countries, and a legal team capable of intimidating even the fiercest plaintiff. Penny stocks, on the other hand, often have a select few clients and revenue streams, so while any advances can really increase the share price, they’re also significantly more vulnerable to any losses or lack of improvement.
In the following sections, I describe some types of events that can dramatically affect penny stocks but that may not be significant to large cap companies.
The bigger a company becomes, such events will have proportionately less of an impact on the shares. Until that point, however, many issues will be of greater importance to penny stocks than mid cap and large cap companies. Although this vulnerability can represent massive downside potential if things go against the smaller business, it also clears the way for dramatic and lasting upside price gains when events play out as hoped.
Lawsuits
Besides being very costly and a distraction for the executives and shareholders alike, the outcome of a lawsuit can have a major impact on a small company.
Suits brought against a penny stock are usually a massive financial drain and, if the company loses, can mean lights out. When the penny stock is the one launching the suit, the action may demonstrate the company’s commitment to defending its products or patents through the courts; and if it comes out in the end with a good settlement or a victory, the results may be very beneficial. This assumes that it has the funds to see the litigation to the end.
Larger corporations devote a smaller percentage of their income to pay legal bills and have the financial luxury and insulation to launch or defend numerous court battles as they see fit.
Regulatory approvals or denials
FDA approval, a trademark grant, or a regulatory body award will have a much more significant impact on the share price of smaller companies. With some single-product corporations, a clearance or allowance is everything – without it, they go out of business; with it, they could change the world. On the other hand, a large cap corporation with 55 patents may not see a major impact when it wins its 56th patent.
Employee poaching or brain drain
Losing key employees is a very common problem for penny stock companies, especially among specialized technology companies. Bigger nanotech corporations, for example, often lure employees away from smaller nanotech businesses. The large cap companies can pay more and head-hunt more aggressively, while struggling and new penny stocks have a tough time thwarting these efforts. In some cases, a larger company will buy an entire smaller company for the sole purpose of gaining the employees.
Intellectual property events
The development and subsequent legal defense of trademarks, patents, and other intellectual property is very costly and time consuming, but such protections can help tiny companies level the playing field. Being granted the right patent can suddenly make a $500 billion corporation stop certain activities, pay royalties, or negotiate various aspects of its business. As such, intellectual property awards can have proportionately more impact on the shares of a smaller company.
Financial results
Penny stocks are often so new and small that the financial results demonstrate a lot more than just the numbers. Implied within the data is the validity of the product, the demand among customers, the growth trend, and client retention levels. When a micro cap company says that its sales increased
