Penny Stocks: What are they and do they make good investments?

• Low-price: The U.S. Securities and Exchange Commission (SEC) defines penny stocks as any stock that isn’t listed on a national exchange and trades for under $5, but some penny stock investors use $1 as their limit.

• Small companies: These stocks are usually associated with smaller companies and are therefore referred to as “micro-cap” stocks. Definitions vary, but micro-cap stocks tend to be shares in companies with market capitalizations of between $50 million and $300 million.

• Over-the-counter: Most penny stocks are sold over-the counter, either on the pink sheets or over-the-counter bulletin board (OTCBB). Many investors and brokers also consider larger over-the-counter stocks to be penny stocks, regardless of their share price or company size.

• High potential, high risk: Penny stocks are considered very risky securities due to minimal oversight and low liquidity. However, since they sell for such low prices, there also is potential room for growth.

• Low liquidity: Penny stocks have a lack of liquidity compared to blue chip stocks sold on the New York Stock Exchange (NYSE) or Nasdaq, which means they may face high volatility. It also opens up the opportunity for some traders to manipulate stock prices, particularly through pump-and-dump schemes.

• Lack of publicly-available information: Companies with penny stocks tend to be newer, which means they may not have track records and it can be difficult for investors to assess how the company is truly performing. Micro-cap stocks also sometimes are approaching bankruptcy, making them highly risky investments.

• Limited reporting requirements: Companies listed on OTC markets don’t have the same regulatory requirements as those on major exchanges. This includes many penny stocks, which may have moved to OTC markets to avoid these requirements.

• Potentially unprofitable: Low liquidity can make it difficult to turn a profit on penny stocks if it becomes difficult to get out of the position. In fact, many advisors consider penny stocks to be speculative investments due to the high risk of losing your investment. If you invest with Public, you’ll see safety labels on risky stocks so you can make informed investment decisions.

• Fraud: Micro-cap stocks are common targets for scammers, thanks to minimal reporting requirements and low liquidity. Common scams include paid recommendations that direct users to specific stocks, and offshore brokers that resell these stocks at much higher prices than they’re worth.

Editors Tip

• One way to identify promotional material is to look for disclosures at the end of the report. If the writer is being compensated (either in cash or with stock) by the company they’re promoting, it’s an advertisement.

Editor's tip

• Look out for the letter “Q” at the end of a stock ticker. When this is added to the ticker, it most likely means the company is in bankruptcy.

• OTC stocks: Investors looking for alternatives to the stock market sometimes turn to OTC stocks. While penny stocks are usually sold OTC, there are many well-established companies that also sell their stock this way. When you trade over-the-counter, you can also get access to larger companies like Tencent, Softbank, or Nestle that aren’t listed on major U.S. exchanges directly from Public.

• Low-price stocks on major stock exchanges: There are plenty of stocks priced under $5 on the Nasdaq and New York Stock Exchange (NYSE). The trading volumes on these exchanges tends to be higher and, since companies are held to strict reporting requirements, the risk of scams tends to be lower.

• Fractional shares: If penny stocks appeal because of their low share prices, fractional share investing could be an alternative. Public lets you purchase a slice of a stock instead of the whole thing, so you can own pieces of more expensive stock. You can trade fractional shares the same way you would with whole shares.