January 9, 2015    3 minute read

Penny Stocks: Profits & Pitfalls

   January 9, 2015    3 minute read

Penny Stocks: Profits & Pitfalls

With virtually negligible capital outlay and the capability soar over a short period of time, does the penny stock deserve its aura of malignity? Trading at under $5 per share, the penny stock can be viewed as a potential gateway into trading for newcomers.

However, the maxim ‘buy the rumour and sell the news’ could not be more false in this tier of the financial markets; often bounty hunters create hype around an upcoming company – the next rising star – to boost investor sentiment so new investors pile in. The value of the microcap stock soars and the bounty hunters swiftly sell off their stock and leave the new investors on the road to ruin. This is known as ‘pump-and-dump’ and is rife amongst penny stocks.

‘Short-and-distort’ is another tactic employed, with damaging tales told about the target company giving investors in long positions losing but the short-selling manipulators buying back for profit. Infrequent trading of penny stocks presents another pitfall; even if the stock is strong it can be difficult to sell.

Getting into the smaller penny stock upstarts is more hands on than its standard blue chip counterpart, with pink sheets or over the counter transactions conducted through a broker-dealer firm. This firm then contacts the firm who represents the microcap’s owner, and then the transaction is negotiated.

Often, specific analysis of a company’s product/service is more important than the perpetually shifting myriad of market conditions, such as how far into its life cycle is the product, does it have new ideas in the pipeline and how does its balance sheet stack up?

After riding the dotcom wave up to a share price of $114.53, Concur Technologies ran aground in 2001 after a market crash left it drowning at a measly 31 cents. Astonishingly, the stock increased by 34400% and generated almost $1 billion dollars in revenue in 2003. Concur is the flagship penny stock case in point, the success story that gives impetus to start-ups and aspiring traders.

Another peak-trough-peak story is that of the real estate investment trust General Growth Properties; a victim of the global financial crisis and over-optimism at the wrong time. The trust peaked at $67.00 in 2007 and then became heavily geared the next year to acquire more assets, coinciding with the credit markets’ rupture and hence being unable to restructure its debt. This saw a tumble to 67 cents into penny stock territory. Bill Ackman took a chance on the rock bottom stock and rode it up around 3400%, an astounding trade in any context.

On a note of caution, the fact that these stocks fell to such dizzying lows in the first place is enough warning of the volatilities associated with the microstock market. Plenty of investors stand to gain from this microcosm of finance, legitimately or otherwise, but such gains are attached to a significant capacity to fail.

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