Penny stocks are regularly a hot topic of conversation, mostly because of the theoretical potential these companies bring.
After all, penny stock investing is the closest that many folks will ever get to buying in on the ground floor of a trade — and if the narrative holds up and a tiny company makes it to the big time, the profits will be enormous.
But sadly, penny stocks are about 99% hype and only 1% substance — and the shenanigans that surround super-cheap stocks that trade on the pink sheets make them rarely worth the trouble.
The latest glaring example: Retired four-star general Wesley Clark — who you may remember as a potential presidential candidate and leader of the U.S. Army’s operations in Kosovo — has joined the boards of 10 penny stocks in the last decade or so.
The goal, to me, seems pretty transparent: He lends his good name and the veneer of legitimacy to money-losing operations in the hope that investors will overlook ugly balance sheets and simply fall for the high-profile endorsement.
But don’t take my word for it … check out this in-depth Bloomberg report. The payoff paragraph is as follows:
“All but one of the 10 (penny stocks) lost value during Clark’s tenure. Three went bankrupt shortly after he left their boards, and the chief executive officer of one pleaded guilty to fraud. Only four of the 30,958 people in Bloomberg’s database of over-the-counter board members have served on more boards than Clark. ‘His appearance on a board is a huge red flag,’ says Joe Spiegel, whose fund, Dalek Capital Management, made money shorting the stock of one of Clark’s ventures. ‘These companies use people’s names to get legitimacy.'”
Sadly, this isn’t anything new in the arena of penny stocks and OTC market manipulation.
So if you’re thinking of diving into penny stock investing, please take a moment to review these five myths about these investments — and the hard reality of what you’re getting into.
Penny Stocks Myth #1: These Companies Have Big Potential
If you think penny stock investing is your ticket to get in on the ground floor, think again. If anything, penny stocks often offer unscrupulous investors an opportunity to unload their holdings in a company that is going nowhere — and leave you holding the bag.
After all, if they had such a great idea, wouldn’t they have sold it to someone else for billions, or held a massive IPO on a major stock exchange to raise capital and build it out?
If something sounds too good to be true, it usually is. So don’t fall for the idea that you have found the next social media giant in your favorite penny stock — because if that company really was so fantastic, wouldn’t Facebook Inc (NASDAQ:FB) have jumped at it already? After all, Mark Zuckerberg could probably swipe his credit card to cover a $10 million valuation.
Penny Stocks Myth #2: The SEC Will Protect You
Penny stocks are a playground for scams, and aren’t regulated with nearly enough scrutiny to catch all the ne’er-do-wells.
Consider “stock tips” from celebrities like rapper 50 Cent on Twitter, or Notre Dame football legend Daniel “Rudy” Ruettiger charged by the SEC in a pump-and-dump scheme in 2011. Or read about an August 2013 penny stock bust that involved a $140 million fraud ring across 35 countries.
Horror stories like these abound. So don’t rely on government oversight to protect you and keep this corner of the market clean.
Just take a look at this list of six penny stocks suspended a few years back for “delinquent filings,” and you’ll see that many of these stocks are not exactly eager to comply with what little regulation there is.
Penny Stocks Myth #3: Share Price Is Important
Share price simply does not matter — the quality of your investment does. And since investing is a game of percentages and not raw dollars, you should be more concerned with your ability to build on the current price than what the heck the current nominal price is or how many shares you own.
Consider Priceline Group Inc (NASDAQ:PCLN), which traded for $600 in 2012 and is now roughly double that at $1,180. That performance is much better than the roughly 55% gain for the S&P 500 in the same period, even with a high sticker price for each PCLN share.
Or take Chipotle Mexican Grill, Inc. (NYSE:CMG), which is up 70% in the last two years or so vs. 30% for the S&P 500. It now trades at $630 or so per share.
Even if you only had a few hundred bucks to spend, if you had bought just one single share of either of these stocks before their respective runs, you would be way ahead right now.
So don’t tell me expensive stocks can’t outperform.
Penny Stocks Myth #4: Unknown Is Good
Even if your penny stocks are legit, which is a huge leap of faith to take, the problem caused by low volume and investor sentiment makes these kind of investments highly illiquid.
There’s no safe way to control volatility like this — you can be whipsawed around, stopped out for no reason or charged an arm and a leg to buy new shares if you don’t use a limit order.
Think of it this way: If there are 10 sellers each with 1,000 shares for sale today but only one buyer who wants just 100 shares … that buyer can demand a very low price, particularly if one of those sellers is desperate to unload.
Some folks fall in love with the fast-paced world of penny stocks and microcaps, but the horror stories in this space are all too common if you’re on the wrong side of volatility.
Penny Stocks Myth #5: Cheap Today, Expensive Tomorrow
Rather than see penny stocks as small and growing, the reality is that cheap stocks have often fallen from grace … and picking themselves back up is a daunting task indeed.
People like to hold up the example of Apple Inc. (NASDAQ:AAPL) with its return from the brink as the case of a turnaround play that made investors millions. But if you think geniuses like Steve Jobs and iconic companies like Apple are common — and that you’ll find leaders like that running a penny-stock company — well, think again.
Turnaround stories more typically end up with an ending similar to the current narrative at RadioShack Corporation (OTCMKTS:RSHCQ), which is shell of its former self and has been relegated to the pink sheets as a penny stock before it inevitably disappears.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not hold a position in any of the aforementioned securities.