There is a reason penny stocks are often referred to as penny dreadfuls.  Yet many average retail investors simply cannot resist the delightful prospect of massive percentage gains in a matter of days, and sometimes in a matter of hours.  These investors ignore the plentiful advice to avoid using anything other than excess disposable cash to gamble on this kind of investment.  Gambling, they tell us, is what investing in penny dreadfuls really is; nothing more than a trip to the Casino and a roll of the dice.

Why then are penny stocks so popular in share markets world wide?  There are two principal reasons and to illustrate the first and most important, let’s take a look at a ten year price chart that shows both the delightful and the dreadful of one Aussie Penny Stock – Minemakers Ltd (MAK):

Since Australia’s resources boom began a major source for penny stock hunters has been the junior miners.  These companies are typically very small and are engaged solely in exploring for minerals.  A single find or even something as little as a positive geological report can send the share price soaring in the expectation it could be the next big winner.

At the close of 2007, you could have invested in Minemakers – a Perth based phosphate exploration mining company – for around twenty cents a share.  What happened to drive the price to around $2.50 by the close of the first quarter of 2008 may be a matter of historical interest, but in reality, it doesn’t matter.  What matters to investors is the 1400% increase.  That is the ultimate attraction of penny stocks.  American investor Peter Lynch popularised the phrase “ten-bagger” to characterise shares that have appreciated ten times the price paid for the shares.  In the minds of many investors, the opportunities for ten-baggers are more plentiful in the wonderful world of penny stocks.

 

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The second reason they are so attractive has to do with how greed can trump rational thought.  The low share price means a $1,000 investment in a twenty cent stock yields 5,000 shares in your portfolio.  The same amount invested in a $10 stock yields a mere 100 shares.  Although it’s the same thousand dollars, somehow it just seems more reassuring to say you own 5,000 shares instead of 100.  When greed steps in, it is easy to believe the potential for capital appreciation is higher the more shares you own.  We forget about risk and focus solely on reward, salivating at the prospect of finding a share like MAK that could make us rich.  And yes, there are other short-term success stories with other penny stocks.  Here is a ten year price chart for another junior miner, Great Western Resources (GWR):

Greed also allows us to fool ourselves into believing we can do what most investors cannot and that is time our buys and sells perfectly.  We look at a chart like the MAK and GWR examples and when dreaming about how much we could make if only we could find more shares like those, we calculate the profit assuming we bought in at the low and sold at or near the high.  Also based in Perth, Great Western Resources is engaged in exploring for iron ore and gold.  With perfect timing, you could have bought in at $.50 in early 2006 and sold out at $3.25 nine months later.

The charts of both these companies display the main reason many refer to penny stocks as penny-dreadfuls.  They can fall as rapidly as they rise.  What’s more, note that both shares had several dips in price during their dramatic rise.  Investors that bought in on these dips to catch the rising tide ended up losing big when the tide rolled out.  Does this mean you should avoid all penny stocks?

Philip Fisher, considered by many market experts to be the father of growth investing, had this advice for investors in his classic investing book, Common Stocks, Uncommon Profits:

•    Don’t ignore a good stock just because it is traded “over the counter.”

When Fisher wrote those words in 1958 there were no electronic sharemarket exchanges and the penny stocks of the day traded over the counter.  They were harder to research without the reporting requirements we see today on the exchanges, but what Fisher was saying is the low price of a stock does not mean the stock lacks the potential for growth.  And there are real success stories with penny stocks.  Here is a ten year chart of one such success, CuDeco Limited:

CuDeco (CDU) is engaged in the exploration and evaluation of mining properties, mostly in copper.  You can see their dramatic burst in 2006 and since then they have continued  trading well above their prior penny levels.  How do you find the “delightful” companies like CDU and avoid the “dreadfuls” like MAK and GWR?

The Internet has revolutionised sharemarket trading in many ways and one is the advent of the many stock forums and discussion boards.  There you will find some average investors, just like you, who are eager to share the results of their own research into a company with others.  Mining has been the major source of penny stocks in Australia for years and on a good forum you will find individuals who have expertise in mining technology.  However, you will also find something else on those boards – stock spruikers and day-traders.

A spruiker is essentially someone whose job is to promote something with tales that often sound too good to be true.  Some boards refer to them as “pumpers.”  They post message after message touting the prospects of a company.  Day traders sometimes frequent those boards as well for the same purpose – pumping up a share price regardless of the real prospects of the company.  Spreading rumours is another common strategy for pumping up a share price.

In the United States, promotional companies are hired to spring elaborate “pump and dump” schemes on unsuspecting investors.  A select group of speculative investors buys into a company at penny prices and then the massive pump campaign begins.  Investors find their email inboxes crammed with information on the latest hot prospect, coming from multiple sources, all of them seemingly credible.  So they begin buying.  Penny stocks generally are thinly traded so it doesn’t take much to drive the price up and at some point, the speculative investors dump their shares, driving the price down and leaving the average person “holding the bag.”

There are better sources to look for penny stock prospects.  You can check the 52 Week High lists and the Insider Buying Lists published daily on sites like TheBull.com.au for targets.  However, if you want to avoid getting burned you need to do your homework, perhaps even more so than with the shares of larger companies.  Penny stocks always have a story to tell, and there are specific things you can do to help determine whether the story is little more than a fairy tale.

First, thoroughly investigate the experience of company management.  Some of these penny stocks are run by people who have had experience in larger companies in the same industry.

Second, it isn’t always necessary for a junior miner to be run by a geologist, but you need to check the technical expertise the company has at its disposal.  Who are the experts they employ and what have they done?

Third, investigate the experience of the members of the Board.  Look for people with entrepreneurial experience as well as experience with companies who have yet to turn a profit.

Fourth, you need to know where the cash is coming from and how fast the company is spending it.  Companies with a high burn rate can run out of money to continue operating even when prospects are improving.

Fifth, you need to know where the company’s operations are located.  Today many junior miners are looking outside Australia and there is “sovereign” risk involved in doing business with governments that might not be business-friendly.  You also need to know whether another company is exploring in the same geographic area.

Finally, price targets with penny stocks are even more important than with larger companies.  The rapid fall of these shares if the story behind them goes bad can be mercilessly quick.  Many penny stock investors with “ten bagger” profits have lost it all waiting for a “twenty bagger”.