Penny stock get a lot of press, especially in rising markets. What is a penny stock, and how do you invest in penny stocks?

For US investors, a penny stock is typically thought of a common stock that is currently trading for under $5 a share, and is not on one of the major stock exchanges, but is traded over the counter ( aka OTC) and quotes are provided through the Pink Sheets or the OTC Bulletin Board. Typically, stocks listed OTC tend to have low market capitalization (basically the total value of the entire companies stock) and don’t have a lot of trading volume (are “thinly traded”). Even if there is a lot of share volume, since the price is so low there is not a lot of dollar volume. This in itself can lead to a lot of volatility in the stock price.

Other names for penny stocks often include small caps, microcaps, and nano caps. Investing in penny stocks can be a challenge for the average investor. Let’s take a look at some of the issues penny stock investing presents.

Liquidity - Much of the time these stocks are thinly traded, that is there is not a lot of volume in the stocks. This makes it harder to get in and out of the stock, and this usually can be seen by the fact that there is a large bid - ask spread. Bid - ask spread is just the difference between what the market maker is selling the stock for vs what he is buying it for. One problem with low price stocks is that for a stock trading under a dollar, even a relatively small spread like 1/16 is still over 6%, which means the stock price would have to go up over 6% for you to just break even.

Company information - Companies whose stock trade on the major stock exchanges are required by the SEC to make certain financial filings or disclosures. Investors have this information to help them determine companies “fundamentals”, basically assess the companies prospect, and are key to investors who want to practice value investing. Many penny stock companies don’t make these disclosures since they aren’t listed on the exchanges, so making sound decisions are more difficult.

Fraud and Advisory Services - Investors are attracted to investing in penny stocks by the fact that if the stock rises only a fraction of a point, that translates into a large percentage swing. Couple that with the low stock price and the ability to buy hundreds or thousands of shares with a relatively small investment, and it gives the impression of you are buying a lot of the company. Add in the lack of readily available information on many of the companies, and the fact that a thinly traded stock can be moved by just a few investors jumping in, and the stage is set for a lot of fraud.

Schemes like pump and dump, where an individual buys a stock and then “pumps” it by sending out spam email, posting on investment forums, etc. and then “dumping” it when they buying surge hits. This is the same basic idea used by some fraudulent “investment advisors” as well, where they “recommend” the stock, wait for it to run up, and then sell out their positions.

If you want to invest in penny stocks, probably the best approach is to find an advisor that has a track record that is documented by a legitimate service like the Hulbert Advisory service. Examine the record of their previous recommendations, and don’t pay attention to the sales letter.

Investing in penny stocks can be tough. There are many legitimate companies that are just starting out, and may become the next Microsoft. Value investors know that the real money to be made in value investing is most easily found in the smaller cap stocks. But you need to make sure you find legitimate information when investing in penny stocks, or you may end up losing all your pennies.