That's why a clear understanding of how to buy penny stocks is essential before diving in to the market.
You see, behind the potential for large gains is the indisputable fact that many of today's most dynamic companies were once little more than penny issues themselves.
That means that at least a few of tomorrow's market leaders are currently lurking among stocks listed on the Over-the-Counter Bulletin Board (OTCBB) or the so-called "Pink Sheets."
Penny Stocks That Hit it BigAs proof, consider just three examples.
These are companies that have risen from true penny status to positions of prominence handing early and enduring investors almost unimaginable profits:
- Green Valley Coffee Roasters Inc. (Nasdaq: GMCR) - Thanks to four splits, 100 shares purchased in October 1998 at $4.62 a share ($462) is now 2,700 shares priced at $20.45 a share, worth $55,215. But the stock actually hit $107.99 in September 2011, making it then worth $291,573.
- Bally Technologies Inc. (NYSE: BYI) - Two splits turned 100 shares of this gaming-machine maker purchased at $1.69 a share ($169) in May 2000 into 400 shares, now priced at $45.98 and worth $18,392.
- Jos. A Bank Clothiers Inc. (Nasdaq: JOSB) - You could have purchased 100 shares of this clothing retailer in November 1999 at $2.78 a share ($278). After four splits, that position has turned into 351 shares now priced at $41.29, worth $14,492.79. At the height in May 2011 those shares were $56.05 each, worth a total of $19,673.
It doesn't include the many penny mining stocks that exploded upward with skyrocketing resource prices or "fallen angels" like Bank of America (NYSE: BAC). A complete listing of such stocks would go on for pages.
Of course, a listing of stocks that have gone from penny status - defined by the Securities and Exchange Commission (SEC) as "a very small company priced below $5.00 per share" - down to zero would be far, far longer. That's why these stocks are among the riskiest on the board.
That's the challenge for investors - avoiding the big losers in the penny stock market.
How to Evaluate Penny StocksTypically, companies in this price range may be based on a single idea or a lone product. If it fails, so does the company. Tangible assets will be limited - often under $5 million, or even less if the firm is only a couple of years old. Annual revenues, if there are any, will also be small - averaging $5 million or less.
Because of these financial weaknesses, typical methods of fundamental analysis used with larger firms are often meaningless, requiring potential investors to take a different approach.
J. David Stewart, who prior to his untimely death ran one of the country's most successful small stock advisory services, suggested looking at these factors when considering a penny stock purchase:
- Appeal of product or service - Would you personally buy what the company is selling or see a need for it in your future.
- Commitment of management - Stewart never recommended a company without interviewing its CEO and other top officers. While you can't do this, it's fairly easy to find out if the founder is still actively involved in running the company and promoting its product or service.
- A good business model - If the founder is an inventor or "idea man," has he been smart enough to bring on a quality business manager or financial officer to ensure the company is properly structured and run according to sound business principles.
- Effective marketing - A great product is worthless if it's not being sold well.
- A positive return on equity (ROE) - This is the one fundamental measure that's of value. It's determined by dividing net income by shareholder equity and a positive return, no matter how small, is a sign of quality in revenues, indicating the company is on its way to profitability.
- Insider buying - You don't want to buy a stock if the people running the company don't own it too.
- A steady rise in price and trading volume, even if small - This signals increasing awareness of the company and a pattern of legitimate growth, as opposed to the big surges in price and volume often seen in low-priced stocks being used in "pump-and-dump" scams and boiler-room promotions.
Put an equal amount of money into 10 penny stocks, he said, and odds are five will go broke, three will continue to chug along in the penny price range and two will turn into ten-baggers - which will give you a return in excess of 100% on the entire package.
How to Buy "Penny Stock" FundsIf finding ten good penny candidates using the above criteria seems like too much work, there is an alternative to creating your own fund - an exchange-traded fund (ETF) specializing in micro-cap stocks.
Two of the top ones - with enough volume and liquidity to ensure efficient pricing, which you won't find in many individual penny issues - are:
- iShares Russell Microcap Index Fund (NYSEArca: IWC): This fund tracks the bottom 3% of the U.S. stock market, based on capitalization, and is a favorite of the pros with institutions holding about 45% of the shares. The capitalization is around $500 million and the shares have options for those looking for a shorter-term trading vehicle. It even pays a modest dividend (which you'll rarely find on a penny stock), yielding about 1.5%.
- Vanguard Small-Cap Fund (NYSEArca: VB): This is a passive fund structured to track the performance of the MSCI US Small Cap 1750 Index. It has a market cap in excess of $4 billion, and pays a small variable dividend.
Still, if you're willing to do some research and show some patience, you might wind up with an amazing reward - say one like that provided by pharmaceutical giant Mylan Inc. (Nasdaq: MYL).
Had you bought 100 shares of MYL in 1976, when it was a fledgling start-up priced at 75 cents, you'd now have 22,780 shares with a price of $21.23 - worth nearly half a million dollars.
That's a gain of over 6,000,000% -- quite a tempting reason to learn how to buy penny stocks.
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