Penny Stocks: Complete Guide on How to Invest in Stocks Under $5.00

penny stocksThe reason to invest in penny stocks is simple—investors can make large profits by investing in stocks before they turn into successful corporate behemoths. But reward never comes without risk and investors should read this primer on how to invest in penny stocks before jumping into the action.

What Are Penny Stocks?

As is implied by their name, penny stocks have a low stock price, say below $5.00, and the entire company is not worth a lot. The company size as measured by market capitalization (share price times number of shares outstanding) would be less than $2.0 billion for small caps and under $250 million for micro caps. For some perspective, General Motors Company (NYSE/GM) is worth $60.0 billion.

Another distinguishing factor of investing in penny stocks is the exchanges they trade on. While General Motors trades on the world’s biggest stage, the New York Stock Exchange (NYSE), penny stocks trade on over-the-counter markets (OTC). These exchanges lack a physical location, like 11 Wall Street, the home of the NYSE.

Moreover, when buying and selling penny stocks, investors are dealing with a broker/dealer who sets the price. This is unlike most public exchanges where investors interact directly with another market participant through an order matching system. In the OTC markets, the broker makes the market for a particular stock wielding power over the quoted price and availability of a particular penny stock.

Practically speaking, there are three levels of OTC exchanges for penny stocks. The first mentioned are the most transparent and the latter have no financial reporting requirements. OTCQX is a market designed for large international organizations, often looking to have a listing in the U.S.; this is for firms that are current and consistent with their required financial disclosures. Companies listed on this exchange include: Roche Holding AG (OTCMKTS/RHHBY), a Swiss pharmaceutical giant; Canadian Oil Sands Limited (OTCMKTS/COSWF); and Yamaha Corporation (OTCMKTS/YAMCY), a musical instrument and motorcycle manufacturer with a market cap of $3.6 billion. (Source: OTC Markets web site, last accessed April 20, 2015.)

The other two over-the-counter markets are titled OTCQB, or simply the “bulletin board,” and OTCPINK, infamously known as the “pink sheets.” Companies listed on the bulletin board are high-risk, development-stage companies that are current with reporting requirements, but are not of high enough quality to list on the OTCQX. Another step up the risk curve and down the quality ladder will take you to the pink sheets. Penny stocks listed here have no formal reporting requirements; the only requirement for trading is the need to have a broker willing to make a market for your shares.

Investing in Penny Stocks

The first step toward investment success in penny stocks would be to avoid as much of the junk as possible, namely the bulletin board and pink sheet stocks. The best way to avoid high-risk, low-reward penny stocks is to consider only companies worth more than $250 million by market capitalization and that have an average trading volume over the last 30 days of about 100,000.

Following this rule would not have helped you avoid Enron, Nortel Networks Corporation (OTCMKTS/NRTLQ), or Lehman Brothers, but it’s a great starting point. These penny stocks will have greater liquidity, greater financial transparency, and possibly lasting businesses.

Running this sort of filter greatly narrows your focus and simplifies the decision-making process. Those looking to dive right in can run their own penny stock screen based on market value and volume criteria by visiting the OTC Markets web site stock screener.

Two examples of the kinds of stocks that meet value and volume criteria were Fission Uranium Corp. (OTCMKTS/FCUUF) out of British Columbia with a market worth of $342 million, and Kroton Educacional S.A. (OTCMKTS/KROTY) the largest private education provider out of Brazil. At this point, investing in and trading penny stocks requires that investors take a closer look.

How to Make Money in Penny Stocks

What you are counting on at the end of the day is that your penny stock investment grows exponentially, that the business increases in size and garners attention from institutional investors, such as mutual funds, and is eventually covered by analysts. For a penny stock to achieve success, the underlying business model must be sustainable, the financials strong, and management must be focused on shareholders.

Keeping this in mind, I strongly suggest that penny stock investors look at the regulatory filings that companies submit to the U.S. Securities and Exchange Commission (SEC). Accessing these documents can be done by directly visiting the SEC web site or by visiting the investor relations webpage of the company which you are researching.

Investors want to look at the company’s latest annual report (Form 10K) or quarterly filing (Form 10Q), keeping an eye on the following:

  1. A strong balance sheet: Look for a large and growing cash balance and manageable debts on the liabilities side
  2. Consistent earnings history: Examine past earnings to discern a trend and the volatility of results
  3. Management stewardship: Management compensation that is in line with shareholder interests

Unfortunately, there are no shortcuts and doing your due diligence is a must. Of the above quality-discerning criteria, I believe management stewardship is the most important and most difficult to grasp. Management compensation should be reasonable to the size of the company, should preferably be in the form of options to buy company shares, and must be transparent—without special clauses.

Fundamental analysis, as outlined above, isn’t without flaws and even professionals can come to differing opinions after looking at the same information. The problem is that one mistake can be costly, as penny stocks can easily gravitate towards zero dollars—wiping out your entire investment. The best way to avoid such hardship is to employ a basket approach, spreading out your investment dollars over several stocks. This way, investors can limit their downside potential in one stock and have a better chance of holding a penny stock that grows exponentially on the road to becoming a household name.