The perils of penny stocks lurk in wait for unwary

Learn the pitfalls before investing in such `bargains'

Dollars & Sense

March 04, 2001|By George E. Nichols | George E. Nichols,MORNINGSTAR.COM

Now that tech stocks and other richly priced equities have been smashed, investors are more aware of the downside associated with such risky investments. However, I think that market observers need only look to the world of penny stocks to see that speculative fever is far from dead.

Investors chasing penny stocks often delude themselves into thinking these stocks are bargains. But investors need to know the dangers associated with penny stocks.

What is a penny stock? The Securities and Exchange Commission provides an official 1,000-word definition but, loosely speaking, these are stocks that trade for less than $5 per share. The recent incineration of e-commerce companies has created a new generation of these stocks. So far, their track record hasn't been very good - high-profile names such as Pets.com and MotherNature.com have recently liquidated after languishing for months in penny-stock territory.

Other e-commerce firms fallen from grace include Webvan and Buy.com. After burning through mountains of cash, these firms have become infirm. Most penny stocks are in similar shape, making them high-risk/low-quality investments. But if investors avoid penny stocks, they can find plenty of high-risk/high-quality companies, including those on our list of Internet-stock Analyst Picks.

Beginning investors with little cash to spare sometimes believe that these stocks are attractive because they're "cheap." But that reasoning is absurd - these companies tend to be burning lots of cash and have little in tangible assets. So, if a stock is trading at $1 per share now, it could certainly fall to zero.

A better alternative for investors is to find a low-minimum mutual fund, providing a diverse portfolio at a low cost.

There are additional red flags to worry about with penny stocks - most either don't trade on a major exchange or are on the verge of being delisted. Such stocks are listed on the Over-the-Counter Bulletin Board or the National Quotation Bureau (Pink Sheets).

Listing requirements for these electronic quotation systems are much less stringent than what you'll find on the major exchanges such as the Nasdaq, which sets minimum standards for net tangible assets, market capitalization and other financial metrics.

The Pink Sheets standards are even more lax - they don't require a stock to have current financial filings with the SEC. Despite the dangers, these stocks are increasingly popular. Trading volume on the OTC BB is up nearly 10-fold in the past five years (even though nearly half these stocks were delisted in the past two years).

It's difficult for investors to research Bulletin Board stocks because most of them lack analyst coverage. In lieu of legitimate research, investors often make the mistake of buying stocks based on advice from message-board posts.

The stock with the busiest board at Raging Bull during most of 1999 soared about 1,200 percent in the first half of that year. Despite those quick riches, this OTC BB stock has been a poor long-term investment - it has tumbled nearly 95 percent since August 1999, after the Royal Canadian Mounted Police raided the firm's headquarters (on suspicion of illegal gambling and child pornography violations).

A new study co-authored by DePaul University examined the returns for OTC BB stocks from 1995 to 1998 and has concluded that "surprisingly ... the higher risk for these stocks did not bring higher returns" compared with a portfolio of exchange-listed stocks. Highly volatile stocks that offer inferior returns - gee, where do I sign up?

To be sure, there are some solid companies that trade on the OTC BB - one name that comes to mind is Benjamin Moore, the paint company purchased by Warren Buffet's Berkshire Hathaway for $1 billion in December. However, this is an exceptional case, and doesn't change the fact that most of these stocks are little more than lottery tickets.

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