Penny Stocks Explained: High-Risk Gamble or Hidden Gateway to Big Profits for Beginner Investors?

The US stock market and the cryptocurrency industry have made many people wealthy in a short span since the end of the COVID-19 pandemic. Social media and news outlets are flooded with success stories of people becoming millionaires overnight, claiming to have cracked the perfect algorithm of timing the market.

It can be said that the pandemic had a positive impact on how people perceive money. The years of economic instability and job losses drove families to save and invest more, seek financial advice, and build long-term financial plans. The advent of the fintech industry, particularly robo-advisors and trading apps, has also encouraged many to venture into the stock market as they attempt to mimic the strategies of financial advisors using complex algorithms for a hands-off investing approach. Many investment platforms allow people to invest as little as $1.

However, the growing trend of achieving higher gains faster with lower capital has also led people, especially younger generations with little to spare, to invest in penny stocks. What are they?

Essentials of Penny Stocks

Penny stocks often attract investors seeking substantial returns from smaller investments. These stocks trade at low prices, usually under $5, on over-the-counter markets or so-called pink sheets rather than major exchanges like the Nasdaq or the NYSE. They are typically issued by companies with a market capitalisation of less than $300 million, and generally exhibit traits of low liquidity and higher volatility.

These stocks are issued by lesser-known or early-stage companies, offering investors the potential for rapid capital appreciation if the businesses take off. For instance, a successful product launch or a positive financial report can lead to sudden, steep stock price gains. However, these gains could be short-lived, and investors may have a small window to cash in.

Savvy investors with a deep understanding of business fundamentals and the broader market often look for undervalued or overlooked companies to buy in before the stocks gain wider popularity due to a future business milestone.

The low barrier to entry and the 'get rich quick' appeal attract new investors into these speculative markets, which also carry a higher risk of losses.

The Reality of Penny Stock Trading

Penny stocks on the OTC Bulletin Board or Pink Sheets should be approached with extreme caution because they have fewer listing requirements than major exchanges. Stocks trading on Pink Sheets could be more risky for investors, as these companies are not required to file with the US Securities and Exchange Commission, unlike OTCBB stocks.

However, investors should not get their hopes up, even for trading on the OTCBB, as it is difficult to find adequate information to form a solid conclusion on whether the company is likely to survive, let alone thrive. Furthermore, penny stocks are highly volatile but have low trading volume, which can make it difficult to sell at a desired price.

The real risk lies in price manipulation. In this digital age, penny stock scammers are getting richer by luring new and inexperienced investors, especially through social media, streaming platforms like YouTube, and even penny-stock newsletters, into investing in worthless companies and ultimately taking their money.

The nature of penny stock markets makes them a big target for 'pump-and-dump' schemes and a range of other fraudulent activities. The pump-and-dump schemes are widespread, with promoters rally interest in an unknown company that traps investors to buy its shares, which increases the stock price. Once inflated, the bad actors dump the stock at huge profits, causing the victims to lose their entire investments.

Another scammer tactic investors should be cautious of is the 'No Net Sales Fraud,' where scammers offer shares with conditions stating that they cannot be resold for a certain period of time. Investors are often told there is a huge demand for the stock. By the time regulators work to clamp down on these scams, investors are usually left with nothing.

There are also offshore rackets, where companies operate outside the US but manage to sell their stocks to US investors. Scammers purchase cheap and unregistered foreign company stocks and sell them to investors at higher prices. This influx of unregistered shares causes the stock price to decline, as scammers profit while US investors receive little to nothing.

Here's How Beginners Can Avoid Penny Stock Scams

Evidently, the penny stock market is rife with market manipulation and fraud. In order to stay protected, traders should diligently follow a set of simple rules.

Identifying Stock Advertisements

A penny stock investor must learn to distinguish between stock promotion and genuine equity research. Promoters often hire newsletter writers to curate flattering reports about their stocks, portraying a convincing case for investing in worthless penny stocks. These reports often feature impressive projections and resemble legitimate research reports. Beginners can identify a legit report from a false one by reading the disclosures section at the end of the report to see whether the writer is compensated by the company they are recommending. In that case, it is an advertisement and not a research report.

Assess Management Expertise, Financial Reports

Regardless of listing status, a company's success is mainly tied to the expertise of its senior management. As a penny stock trader, you must find out if the company's top execs have adequate experience and track their history of successes or failures.

In terms of financials, the problem is that penny stock companies generally don't publish detailed financial data. However, it is crucial that you analyse all financial statements it releases, including balance sheets, to track records of outstanding debts or liabilities and cash on hand.

Scrutinise Disclosure Quality

Always follow the thumb rule: more disclosures equal a higher level of corporate transparency.

The OTC Market Group segregates its securities into a three-tier marketplace, where the OTCQX is the top tier, followed by the OTCQB middle tier and the OTC Pink bottom tier based on the integrity of company operations, disclosure levels, and investor engagement.

As the bottom-tier company reporting can be sketchy, OTC Markets Group further segments OTC Pink based on the information provided, into Current Information, Limited Information, and No Information.

If you encounter a stock with the Caveat Emptor sign, it is best to stay away. Stocks usually earn this symbol when the company or its insiders are under investigation for fraud, or the company may be involved in dubious promotional activities.

Overall, penny stocks are a huge gamble. It is better to buy companies with established financials and a strong track record trading on major exchanges.

Disclaimer: Our digital media content is for informational purposes only and not investment advice. Please conduct your own analysis or seek professional advice before investing. Remember, investments are subject to market risks, and past performance doesn't indicate future returns.