4 Penny Stock Myths Used to Target the Next Sucker

By Gwynneth Anderson
January 11, 2011

The Great Recession of 2008-2009 is this generation's economic equivalent of Hurricane Katrina. From underwater mortgages to squabbling elected officials, investors are struggling to reconcile years of conscientious saving against a landscape of devastated 401(k) accounts.

Those seeking to quickly recoup their losses might be tempted to stray into the dangerous territory of penny stocks, where, theoretically, a small investment can result in big gains.

Forever immortalized in the film "Boiler Room," penny stocks occupy a unique position in American investing lore. After all, where else can an investor spend a few dollars only to reap hundreds in profit in just a short time? How about Vegas?

While there have been instances where penny stocks turned into legitimate home-run investments, in the aggregate, this kind of risk-taking is more likely to take an investor from riches to rags rather than the other way around.

Hard times can push desperate but otherwise rational investors into making irrational choices. While most prudent investors might scoff at penny stocks, there are plenty of people still falling for get-rich-quick schemes.

Here are four of the most dangerous myths used to lure investors into the black hole of penny stock investing:  

Myth #1: It's Not a Penny Stock -- It's a Micro-Cap

While "micro-cap" certainly sounds more respectable than the tawdry "penny stock" moniker, it's just a snazzier way of describing the same thing.

Penny stocks are defined as low-priced (ranging from pennies to $5), low volume, highly speculative shares offered by very small, new companies with no track record. Shares are typically traded on the over-the-counter (OTC) market that requires few minimum reporting standards compared to the Big Board exchanges. 

The SEC defines micro-cap stocks as the same thing -- shares from companies with limited assets that are primarily sold on the over-the-counter (OTC) market. The agency also puts some hard numbers behind the limited asset claim, estimating that their average suspended micro-cap company had only $6 million in net tangible assets, half of these less than $1.25 million.

The SEC has the power to suspend trading in stocks of companies they believe are presenting false or misleading information to investors. The SEC keeps a special eye on micro-caps: Suspensions will typically include investigations into whether the company is little more than a post office box number and ticker symbol.

[InvestingAnswers Feature: Micro-Cap Stocks: The Best Investment Class for Bulls]

Myth #2: Penny Stocks Are So Easy to Buy, Anyone Can Do It

Considering that at the beginning of 2010 investors had over 3,000 OTC-listed micro-cap companies to choose from, this myth is indeed true.

But while technically true, keep in mind that buying is just half of the investing equation.

Whether investors choose to go through a broker specializing in penny stocks or one of the many large national chains, it's certainly easy to buy penny stocks.  The problems arise when it's time to sell the shares. 

Since penny stocks are very thinly traded, it can take several days to divest your holdings. At best, a slow settlement could cost you a portion of your paper profits. At worst, a sudden drop in share value while you're waiting for settlement can mean you're left with a nasty loss.

Little publicly available information, no minimum reporting standards, minimal performance history and an overall lack of liquidity -- all of these turn penny stock trading into little more than gambling.

Myth #3: This Is Your Last Chance to Buy Before the Stock Shoots to the Moon

Imagine getting the following call from a stock broker: "I just got this great stock tip!  XYZ Pharmaceuticals is getting FDA approval on this incredible new weight-loss drug next week. I guarantee this stock's gonna go straight through the roof. We can get you in at $2.50 a share, but you have to commit at least X dollars by the end of today.  Tomorrow is too late."

#-ad_banner_2-#Always remember this fact: Reputable companies have no need for cold-calling salesmen to plug their shares. Wall Street research analysts make big bucks selling their research to paying clients. If you knew a stock was set to soar, why would you give that information away for free?

Investors should quickly run the other way when told a hot deal will soon vanish. Why?

If you don't, you'll be the next victim of the infamous "pump and dump." 

Thanks to email newsletters, online bulletin boards and stock chat rooms, penny stock traders have a venue to pump up penny stocks to a certain price just so they can turn around and dump it on someone else. It's also known as "The Greater Fool" strategy. I don't think I need to tell you who they think the Greater Fool is.

Myth #4: Microsoft and Walmart Were Penny Stocks Once

False.

Reputable companies are able to raise cash from private investors until growth makes an IPO worthwhile.  There are thousands of venture capitalists, private equity firms and commercial banks looking for good companies in which to invest.

Neither Microsoft (Nasdaq: MSFT) nor Walmart (NYSE: WMT) were ever penny stocks.  A simple Google search reveals that Microsoft's 1986 IPO priced shares at $25.50, while Walmart's 1970 IPO priced shares at $16.50.

However, there are certainly cases of large, publicly traded companies that find their stock priced under a dollar.

While many investors were forced to hunker down during the tempestuous 2008-2009 upheaval, those with extra cash went bargain hunting. They snapped up shares of Citigroup (NYSE: C) for under $1, Office Depot (NYSE: ODP) at 59 cents, Ruby Tuesday (NYSE: RT) at 95 cents or Zales (NYSE: ZLC) at $1.11. More recently, the May 2010 flash crash offered nimble-fingered traders the chance to snap up underpriced shares, although some of the trades were later canceled.

But these are not penny stocks. True penny stocks are listed on the OTC market and are issued by small companies with no track record and minimal liquidity. Most of these will never make it onto the big boards. Most are doomed to run out of money before ever hitting the big time. And they'll take your investment with them.

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