the most popular is that the investor has limited funds. Whether you have only a few hundred, or a couple thousand, dollars to invest, low-priced shares afford you an opportunity to turn that small amount of cash into something much more substantial.
I always suggest that investors with limited funds, or even those with no funds at all, start off by paper trading, as I detail in Chapter 5. Only after you discover how to find penny stocks of great fundamental quality, and to trade them well, should you venture into using your limited amount of real money.
Risky misconceptions
❯❯ They can’t fall much lower. If a stock falls to pennies from several dollars or more, some investors wrongly believe that the shares can’t go much lower. Don’t make the mistake of comparing any stock to where it was before, because the stock has no memory, and past levels have no bearing as to where it may go from here. For example, even a stock that fell 99 percent – from $5 to 5¢ – can go a lot lower, and might just be on its way to 0.
❯❯ It’s not a big investment. If you invest $500 in a stock rather than $5,000, you’re risking less money (or, to use investment lingo, your downside is limited to $500). But the size of your downside has no bearing on whether the underlying shares are a good investment. If your reasoning is that you didn’t invest a lot, you’re gambling. If you buy a stock because it has an outstanding management team, low debt load, and expanding market share, you’re investing.
❯❯ The downside is smaller than on blue-chip stocks. Just because penny stocks are closer to zero than large blue-chip stocks or more expensive shares, it doesn’t mean that they are less risky. A $455 stock can go to 0. A 4¢-penny stock can go to 0. In either case, you can lose 100 percent of your investment.
Small businesses are the source of the majority of economic growth in the United States, and this is probably true in most nations worldwide. In addition, the small-business sector is America’s largest employer.
When small businesses need to raise capital, they often go public by listing stock on the market (I describe this process in Chapter 3). Some of these companies are tiny, or just getting started, and their value is still low, so they often trade as penny stocks. As such, penny stocks are a big part of the economy.
In addition to making significant contributions to the economy, some penny stock companies eventually grow up and become huge corporations with hundreds of employees and share prices of $10 or $50 or more. Most people don’t realize that many corporations that used to be penny stocks helped build the economy from the bottom.
You’re not alone
Buying penny stocks isn’t as unusual of a practice as you may think. You may not realize all the people around you who have invested in penny stocks.
The main reason that you don’t hear about people investing in penny stocks is that most novice or new penny stock investors lose money. They don’t want to talk about the $1,000 they threw away, and so they sweep their mistakes under the rug.
You will hear, or course, from the office jerk who is making money on a penny stock. And you probably heard about it yesterday, and will again tomorrow.
Despite the taboo nature of the subject among investors who have been burned, a quiet and significant army of penny stock traders is busy building personal wealth through these low-cost shares.
Next time you’re at a wedding reception, family reunion, or office party, bring up the topic of investing. See if you can find people who will admit to trading penny stocks. You will certainly find a few, and probably more than you would expect. My guess is that many of them lost money.
Room to grow
In addition to the growing interest in penny stocks, many of the underlying companies are also expanding, making the economic footprint of smaller corporations more significant.
A small company can grow in a variety of ways, including through
❯❯ Market share: A growing market share is a great indicator for the success of the underlying company. If that market share is being taken from direct competitors, a growing market can be an even better sign. Keep in mind, though, that a growing market share may take many months to show up in the earnings or share price of the penny stock company.
❯❯ Revenues/sales: Known as the top line number because it’s displayed on the first line of the income statement, the revenues (sometimes called sales) shows you exactly how much money a penny stock is bringing in by selling their product or service.
❯❯ Employees: Growth in employees sometimes demonstrates an increased focus on capturing more sales. Other times it shows that the company is requiring a greater workforce to meet the increased demands of its customers. In either case, as a company grows, so will its headcount.
❯❯ Mergers, acquisitions, and amalgamations: When two or three companies merge into one, or they are bought out by a bigger corporation, a 10¢-penny stock can quickly increase in value. Of course, the original business model of the smaller company will be significantly changed. These events are also quite costly at first, and thus place an additional expense on the corporation. As well, such events are not always great for investors because, although the new company may be bigger and worth more, the original shareholders may not be given fair value in the new corporation.
❯❯ Recurring billing: You can easily analyze the growth in penny stocks that derive revenues from recurring billing and subscription fees. Track the number of recurring billing customers to have a clear representation of the underlying growth and upcoming revenues.
❯❯ Average order size: When the average order size per customer doubles, total revenues should theoretically double as well.
You know that penny stock investing is risky. You’ve probably heard some pretty scary stories about scam artists and investment dollars disappearing overnight. Although investing well in fundamentally solid penny stocks can be very lucrative, the unfortunate fact is that many of the negative things you’ve heard about penny stocks are all too real.
