Penny Stocks: Low Volume Trumps Their Balance Sheets

When few shares change hands, it's a sure sign to steer clear


I recently got a note asking me to investigate Cymat Technologies (PINK:CYMHF). I only rarely dig into a specific pick given by readers (because of SEC regulations, I cannot offer explicit portfolio advice), but this one was easy.

I think Cymat is the worst investment an investor can make. And I came to that conclusion in about 10 seconds.

Why? Because it has a market capitalization of a mere $5 million and has an average daily volume of just 550 shares.

I previously ranted about the stratospheric risk and opacity of “penny stocks” in a previous post, with the pithy headline: “14,849% Profits in Red-Hot Penny Stocks! … Or Go Bankrupt.” A few writers actually had the gall to malign my integrity for writing such a cautionary article, saying it’s irresponsible of me to call a stock a bad investment without even looking at the balance sheet.

So, I wanted to revisit the topic again, with Cymat today, to prove to you why in 99.9% of circumstances, these penny stocks are bad ideas.

Consider the daily volume, or the number of shares traded on average in a given market session (if you’re unfamiliar with this term or what it means, read more on volume here). At 4 cents a share, that means if you invest a mere $22, you’re “moving” this stock.

It’s simple supply and demand.

Consider this: If there are 10 widgets for sale at $1 apiece and there are 10 buyers, it all works out. But what if there are 100 buyers? Sellers can just sit back and wait for the highest possible price. Some would even engage in price gouging if they could to get an unfairly high price — $2, $5 or $10. Conversely, if 100 widgets are for sale and there’s only 10 buyers, it’s a race to the bottom as sellers low-ball each other with discounts. Everyone wants to unload their wares, so they slash prices to 50 cents, 10 cents or 5 cents.

That’s how a market sets prices. The problem is that in a lopsided market, one side gets to skew prices dramatically in its favor.

Let’s revisit Cymat. What if you choose to buy 2,000 shares for a mere $80? Sounds like a good deal, right? Except those 2,000 shares have to come from somewhere. Some other investor needs to sell his stock. If the average volume is just 550, there won’t be enough shares on the market. And the price will move up and up and up to entice someone to unload their shares. If nobody wants to sell for less than 10 cents apiece? Well, you just spent $200 instead of $80 to buy your stock.

And you just made another trader rich in the process.

Conversely, let’s say you already own Cymat. You want to sell your 2,000 shares at 4 cents a piece to get your $80 back. What if there aren’t any buyers? Well, then the price drops to entice traders. If nobody is willing to pay more than 1 cent, you just got $20 instead of $80 on this trade.

That’s the math on “reasonable” sums of money. Imagine if you were trying to invest hundreds or even thousands of dollars — the price would go haywire!

The reason I don’t do a balance sheet analysis of Cymat is that, frankly, it doesn’t matter. When you play with illiquid penny stocks like this, you can see how the buy price and the trading volume have much more to do with the stock price than the company’s fundamentals.

To be clear, these kind of buyer-seller dynamics can happen on any stock. The difference is that for a big stock like Wal-Mart (NYSE:WMT) or Apple (NASDAQ:AAPL), you have tens of millions of shares trading hands each day — and thus a market that regulates itself rather well most of the time. You’d need one heck of a large order to mess up that dynamic on its own.

With penny stocks like Cymat? Well, you disrupt the pricing simply by placing your trade. That’s a scenario no investor should be in.

Jeff Reeves is the editor of Write him at editor@investorplace??.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook.

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