Are Penny Stocks Worth It?

Are mutual funds and ETFs too boring for you?

Well, you are not alone—from Bitcoin to memestocks, investors are looking for ways to spice up their portfolios. With blue-chip companies at record-high valuations, penny stocks are gaining in popularity. While some investors have made a lot of money through penny stocks, the potential of high returns also comes with a high level of risk. 🚨

Fortunately, there is more you can do than just hope for the best—there are plenty of ways you can minimize the risk when investing in penny stocks.

Unlike with blue-chip stocks—no lack of stats and articles about them—penny stocks tend to be a harder nut to crack. After finding information about a penny stock, it can also be a daunting task to weed out the bad stuff. With many traders taking their advice directly from places like the subreddit wallstreetbets, it’s no wonder that many have lost their shirts. 

There are many different types of penny stocks investors—and attracted by dazzling success stories—hordes of new and inexperienced investors have also found their way to the highly speculative asset. In fact, investors lose a staggering 18 billion USD per year by trading penny stocks. Without the proper knowledge and a strategy in place, it is easy to get burned.

To try to prevent this from happening to you, we’ll tell you exactly what you need to know. In this article, you will learn how to find the right penny stocks, what the different types are, and what to look out for. We will also shine a light on the realistic potential return and the risk you’re taking to get it.

Can I Really Make a lot of Money With Penny Stocks? 💸

Yes—it is possible to make money with penny stocks. That’s the simple answer, the reality is that more than nine out of ten people lose money trading penny stocks. 

If you look around online you can find endless stories written by people who have lost significant sums of money. Even so, it is possible to achieve (high) returns with penny stocks when you do your homework.

Penny stocks have small market capitalizations and therefore offer the potential of higher rates of return if the (often fast-growing) company becomes successful. After all, it’s easier for a small-cap company to triple its earnings than it is for Amazon. The difficulty is finding the gem among the stones.

It’s important to realize that penny stocks are generally short-term holdings and rarely good long-term investments. Emotions can play a big role in the price movement, so you might need nerves of steel to sit through the rollercoaster. 

Penny stocks are notoriously unpredictable and most investors fail to invest in them successfully. With great research—and luck on your side—you can set yourself apart from the herd. 

To do so it helps to have easy and quick access to valuable information and data. Not all brokers offer this, but some premium ones make investing in penny stocks a lot more convenient.

Are Penny Stocks Really That Risky? 🤔

Penny stocks have a reputation for being risky, especially compared to blue-chip company stock. You might already know that, but it’s not just the volatility of the share price you have to look out for. We’ll go over the scams plaguing the market, the lack of information, the relationship between OTC markets and penny stocks as well as investor psychology.

How to Avoid Getting Scammed 👮

In the investing world, scams are not exclusively a penny stock problem, but they are more widespread among penny stocks than among large cap stocks. There are many different types of scams—pump and dump being the most well-known—that you have to look out for.

Is somebody trying to promote a stock to you? Chances are that they are being compensated for this by the company. Stay away from this and always check if something is a promotion or legit research—read the disclaimers! Take a good look at the management’s track record and dive into the financials to look at their liabilities.

The Lack of Information 🔍

Research on blue-chip companies is made easy nowadays by the wealth of information out there. In contrast, penny stocks—most barely having a track record at all—are harder to figure out due to the lack of information on them. 

They tend to be new companies and they are small in size. In addition, they are illiquid assets and often not listed on the major stock exchanges. For these reasons they are rarely followed by analysts, making it a tough job to find reliable data.

Investor Psychology 🧠

We are all susceptible to the psychological pitfalls of investing—even Warren Buffet has fallen into them. With penny stocks, these are amplified by the allure of high returns in a short time frame. 

When we see the share price go up and down like a yo-yo, we imagine ourselves buying in at the bottom and selling at the top—with massive gains as a result. In reality, things often don’t turn out the way we want them to. To have a shot at succeeding with penny stocks, you need to understand how your psychology can work against you.

OTC Markets🤝

Penny stocks usually trade over-the-counter—commonly referred to as the OTC market. Before diving into the world of penny stocks, you need to learn what OTC exactly is as OTC and penny stocks go hand in hand. 

The main issue is that OTC markets have lower liquidity—there are simply fewer buyers and sellers. It’s much easier for the average investor to buy a share on a big exchange like the NASDAQ. 

The lower liquidity leads to bigger fluctuations in share prices and often leads to a big difference in the price the seller is asking versus the price the buyer is offering. On bigger exchanges, the spread is a lot tighter and thus more advantageous for you as a trader. 

How to Find the Gems Among Penny Stocks 💠

We have already mentioned that it’s hard to find (reliable) information on penny stocks, let alone finding the one penny stock that will deliver the gains you’ve dreamed of. Don’t despair, there are things we can look at to help us find the good penny stocks and weed out the bad. 

It is important to look at who is in charge, what the fundamentals look like, and whether the financial ratios look alright. At the end of this section we’ll even get a little bit technical—just a little, promised.

Who’s in Charge? 👔

One of the factors we have to look at when researching a penny stock is the management: Who’s running the place? Does the management have a good track record or are there any red flags? Does the management have a vision and strategy in place for the company? 

After all, you don’t want your penny stock to remain just that—a penny stock. The management should have a solid plan in place to grow the company and subsequently lose their penny stock status.

Look at the Fundamentals 📜

It’s important to look beyond just the share price—after all, the share price is just a representation of what investors think the company is worth based on its fundamentals. Take a hard look at whether the fundamentals justify the share price. 

Marijuana companies are popular investments among millennials and plenty of them are penny stocks. For example, General Cannabis’s share price was $1,86 in February 2021, coming from just around $0,30 half a year earlier. At first glance, it seems like a great buy—but fast forward a couple of months and the stock is down a whopping 30% from its yearly high. 

If we take a look at the fundamentals, we see the company has relatively high debt and isn’t anywhere near profitability. Add the fact that there’s no potential buyout on the horizon and we can see that the high share price earlier this year had little to do with good fundamentals. 

General Cannabis was just caught up in a temporary frenzy around cannabis-related stocks. Let’s look at a company that has seen its share price steadily increase for years now.

There’s a high chance you’ve had a Monster Beverage at least once in your life. What does that have to do with penny stocks? Well, Monster Beverage used to be one—we have to go back to the early 2000s for a moment. The share price was well below one dollar during those years and thus qualified as a penny stock—lucky them. 

Currently, the share price is near $100—disappointed you didn’t scoop up some shares when it was a penny stock? Let’s look at why this turned out to be such a big success—let’s turn our attention to the fundamentals once again. 

After a little digging, we found that even as a penny stock during the early 2000s Monster Beverage was already highly profitable and had a very decent balance sheet. Interest from a company like Coca-Cola seemed likely and eventually, the beverage company took a large stake in Monster.

Rate the Ratios 📑

Something you can’t afford to skip during your research is the ratios—and there are many of them. To prevent you from getting lost in a sea of ratios, we will discuss the most important ones to take a look at. 

Leverage Ratios ⚖ 

We’ll start with the ratios that show us if a company has taken on too much debt—relative to its assets. Leverage ratios let us know whether a company can manage to pay its long-term debt. 

Here we can distinguish between debt and interest coverage. If debt ratios are expanding, ask yourself whether it’s justified by the company’s growth. Interest coverage ratios give us insight into a company’s ability to manage the debt—it’s a good sign when this ratio is high.

Liquidity Ratios 💧

Closely related are the liquidity ratios—we’re looking for a company with high liquidity levels. When these levels are low it means the company will likely have difficulties covering its short-term liabilities. 

Keep an eye out for the cash ratio—any number below 0.5 is considered bad. A company that’s in good financial shape usually has a quick ratio of above 1 and a current ratio between 1.5 and 3.

Performance Ratios 🏆

Performance ratios show us—you guessed it—the performance of the company. Are the (operating) earnings of the company growing sustainably? To find out, we have to look at the profit margins—net and gross. 

Another important number to keep an eye on is the return on assets—are the company’s assets producing revenue? There is—especially with penny stocks—no perfect number for any of these, but it’s a warning sign when these numbers are not improving over time or even deteriorating. 

Valuation Ratios 🔖

Let’s say you found a company with great management, outstanding fundamentals, and ratios that tick all boxes—surely, that’s a good buy! Not necessarily—we haven’t looked at the valuation ratios yet. 

The stock can still be a bad investment when the stock price is overvalued. We could use the P/E ratio—the most common ratio to measure a stock’s valuation—to find out. This ratio divides the share price by the earnings per share.

The issue with many penny stocks is that they often don’t have any earnings(yet), making this ratio unusable. So, we’ll look at sales and cash flow instead—if the company doesn’t have these either, start looking somewhere else. By dividing the company’s market capitalization by its sales and cash flow, we get our price-to-sales and price-to-cash flow ratios. 

By comparing the company’s valuation ratios with other companies in the same sector or with the general market, we can get a good idea of a company’s valuation. The lower the numbers, the better.

How Technical Analysis Can Help You 🤓

Let’s shift gears and get a bit technical. Don’t worry, you don’t have to be a technical wizard to be able to use technical analysis in your favor. Technical analysis can tell us a few crucial things about the share price that fundamental analysis can’t. 

Speaking of fundamental analysis, it’s often hard to do with penny stocks—there’s simply a lack of good and reliable information. All the more reason to add technical analysis to our arsenal of tools that help us buy at the right price. 

Further, penny stock patterns can help us see whether a stock is bottoming out on high volume after a dip—offering us a chance to “buy the dip’’. It can also show us whether a stock is topping out on low volume—a good moment to cash in those gains. 

Volume is key in all of this—we need to know how popular our stock is among other investors. Unless your name is Warren Buffet, you won’t move up the share price by yourself. Technical analysis shows us the stock volume as well, so don’t skip the charts during your penny stock research.

Bring Out The Scanners 🚦

To aid them in their pursuit of the penny stock that will make it big, some investors have turned to scanners. Scanners let you choose the criteria you think a stock should meet and filters out all the ones who don’t. You end up with a small list of penny stocks after scanning—making it that much easier to choose out of a plethora of penny stocks out there.

Scanners, though, are generally based on only a few key components—such as trading volume, performance, and valuation. Combine this with the notorious unpredictability of penny stocks and you see why tools such as scanners are far from perfect. 

That said, there are certain things you can do to filter out the garbage and get a neat list of penny stocks you can focus on for further research. One box a stock should tick is that of a high trading volume—the higher the liquidity, the easier it is for you to get in and out. 

We also want the float—the total amount of shares available to trade—to be less than 50 million. Scanners also help you find stocks poised to move in a big way after a breaking news story—think of a lucrative contract for a company or a similar event. 

Many of the ratios—e.g. current ratio, price/cash flow— we’ve looked at can also be found on the scanning platforms. Scanners can be useful for your research, but remember that they are not the end all be all.

How Different are Penny Stocks from Larger Stocks? 📊

We first need to define what “larger’’ or “regular’’ stocks exactly are. They are usually blue-chip companies—corporations with a large market capitalization, profits that grow year on year, and a dividend to keep their investors happy. 

All the things that penny stocks don’t have—this explains why risk is the main difference between these two categories of stocks. Coca-Cola is a good example of a blue chip company—Coke’s profits grow over time, its market cap is near $250 billion and it offers a nice dividend. What’s not to love?

The Main Differences 🥊

Penny stocks lack the characteristics of blue chips and are therefore way more speculative—that’s also why blue chip companies are often considered to be “boring” investments. A lot comes down to luck when trading penny stocks—blue-chips are way more predictable and less volatile. 

The return on blue chips tends to be more in line with the average return of the market—penny stocks have wild swings up and down and usually end up somewhere far above or under that number. Not just investing in a penny stock is risky—the fields the companies are active in are usually just as risky.

The promoters of penny stocks are often hungry for credibility and seize any opportunity to make potential partnerships or contracts seem more important than they are. Dig a little deeper, because things might not be as impressive as they seem at first glance.

The chance of getting scammed out of your money is fairly low with blue-chips—it’s a different story with penny stocks. The low trading volume and over-the-counter trading make it easier to manipulate penny stocks. OTC markets lack the regulatory supervision under which big regional and national exchanges fall.

Penny stock investors lost out around $39 million after a Californian merchant banker devised a giant pump and dump scheme together with other brokers. They promised people an amazing opportunity to invest in one of their companies—which turned out to exist only on paper. Always be skeptical when people pitch a stock to you and do your own research.

What to Keep in Mind Before Investing in Penny Stocks 💭

We won’t blame you if any of the things we’ve mentioned discouraged you from investing in penny stocks—they’ve earned their bad reputation. If you’re still dead set on having a go at it, listen up. There are a few crucial things you have to keep in mind before you start.

Go Long 🏈

You see a penny stock that’s been pumped up into infinity and you think there’s no way the stock will sustain those high prices. Your first thought might be to take a short position and wait for the inevitable crash to happen. 

The truth is that these opportunities are very hard to find and a big loss in the double digits is not uncommon when the stock you’re shorting is experiencing a short squeeze. Penny stocks are simply too volatile, so it’s best to stick to long positions only.

Turn Up The Volume 🎤

You’re looking for stocks with high liquidity—what is your gain worth when you can not get out of the position? A good number to aim for is a minimum of 100,000 shares traded a day. Don’t bother with stocks priced below 50 cents—a share price under 50 cents combined with less than 100,000 shares traded daily indicates very low liquidity.

Tune Out The Noise 🎧

It’s not hard to find success stories about people becoming rich by trading penny stocks—they reach you through social media, advertisements, and email. Don’t fall for it and assume they’re either false or misleading. 

Pick a penny stock for its great earnings growth rather than the hype created around it. Be skeptical of management as well—they’re often just trying to raise the share price to keep the company afloat.

Don’t Forget to Sell 💸

The potential of quick and hefty gains works like a magnet for investors, but they often forget to sell and see their gains disappear like Houdini. Greed is part of human nature and it’s no different on the stock market—we want to see 200% gains instead of 20%. 

One strategy is to sell half of your position when you have a profit and change the stop-loss level to break-even. Many small wins add up to a big number.

Skip The Counter 🚫

When investing in penny stocks, stick to big exchanges like the NYSE and NASDAQ and avoid the OTC market. The issues we’ve discussed—from low liquidity to lack of regulation—make it a place to stay clear of.  You can find good stuff over-the-counter, but it is much safer to focus on the best penny stocks—usually on the NYSE and NASDAQ anyway—that have great earnings and high volume.

Don’t Put All Your Eggs in One Basket 🧺

You have high confidence in a promising penny stock and there aren’t any issues you’re aware of, so you decide to go all in to hit the jackpot. Suddenly the CEO disappears and the business model turns out to be a farce—causing you to lose all your money after the share price inevitably tumbles. Make sure to diversify across a bunch of stocks to avoid this from happening to you. 

Final Words 📌

Educating yourself—as with all financial assets—is the most important part of investing, so pat yourself on the back for coming this far. You now know how realistic it is to make money with penny stocks, the risks you have to be aware of, and—not unimportant—where to find the ones you’re looking for.

You’ve learned how to use ratios to your advantage, what sets penny stocks apart from large stocks, and the use of scanners as a tool. Finally, we’ve left you with a few final common-sense tips to make the world of penny stocks feel a little bit less like the wild west. 🤠

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