The Nitty-gritty of penny stocks

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Blue Chip companies are made rather than born contrary to the perceptions of some investors. They have to work through the different growth phases/business life cycles everyone else. Unfortunately, some investors believe that the best way to ‘dig for gold’ in shares trading is by scouring through penny stocks in hopes of finding the next JapaulOil, IPWA, Niwicable, C&I Leasing, Cutix in the early 2007 or Capoil, Afroil, Poly Products in recent times. Some analysts express that this is probably not the best strategy.

Understanding a Penny/Micro-Cap Stock:
Technically, micro-cap stocks are classified as such based on their market capitalization while penny stocks are looked at in terms of their price. Definitions of what stocks qualify as penny / micro-cap vary. In the U.S, stock with market capitalization between $50m and $300 m (N6bn to N36bn) is a micro-cap. (Less than $50 m (N6b is a nanocap.)

According to the U.S Securities & Exchange Commission (SEC) any stock under $5 is a penny stock.

While all these categorizations are not outlined in any formal /regulatory documents in the Nigerian context, but generally as a norm or market perception, a stock trading at a price range of N1 and N10 is usually considered penny.

The main thing you have to know about penny/micro stocks is that they are much riskier than regular stocks. For instance, junk bonds (bonds with a rating lower than BBB) are considered a much higher risk than those of investment grade (bonds with a rating higher than BBB). In the stock market parlance, equivalent comparison is penny stocks and blue-chip.

What is the Problem with These Stocks?
Market analysts have identified four (4) major issues which make penny stocks riskier compared to other stocks. These are:

Lack of Information Available to the Public:
A fundamental principle that is always preached by many professional analysts is that the
key to any successful investment strategy is acquiring enough tangible information to make informed decisions. For micro-cap stocks, information is much more difficult to find.

Companies listed on the second and third tiers market are have less stringent requirements especially in relation to disclosures and filling of operational reports with the regulators and are thus not as publicly scrutinized or regulated as those on the first tier board furthermore, much of the information available about micro-cap stocks is typically not from a credible source.

No Minimum Standards:
Stocks on the Second and Third Tier Markets do not have to fulfill minimum standard requirements to remain on the Exchange. Sometimes, this is why the stock is on one of these markets. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.

Lack of History:
Many of the companies considered to be micro-cap stocks are either newly formed or approaching bankruptcy. These companies will generally have a poor track record or none at all. As you can imagine, the lack of histories of companies only magnifies the difficulty in picking the right stock.

Liquidity:
When stocks do not have much liquidity, two problems arise: first, there is the possibility that the stock you purchased cannot be sold. If there is a low level of liquidity, it may be hard to find a buyer for a particular stock, and you may be required to lower your price until it is considered attractive by another buyer. Second, low liquidity levels provide opportunities for some traders to manipulate stock prices, which is done in many different ways - the easiest is to buy large amounts of stock, hype it up and then sell it after other investors find it attractive (also known as pump and dump).


The Problem for Investors
Penny stocks have been a thorn in the side of the regulators for some time because microcap stocks' lack of available information and poor liquidity make these groups of stocks an easy target for fraudsters. There are many different ways these people will try to part you from your money, but here are two of the most common:

* Biased Recommendations – Some micro-cap companies pay individual analysts to recommend the company stock in different media, i.e. newsletters, financial television and radio shows. Look to see if the issuers of the recommendations are being paid for their services as this is a giveaway of a bad investment and make sure that any press releases are not given falsely by people looking to influence the price of a stock.

* Off-Shore Brokers– This is does not relate to Nigeria system. In the advanced markets like the U.S, under regulation S, the SEC permits companies selling stock outside the U.S. to foreign investors to be exempt from registering stock. These companies will typically sell the stock at a discount to offshore brokers who, in turn, sell them back to U.S. investors for a substantial profit. By cold calling a list of potential investors (investors with enough money to buy a particular stock) and providing attractive information, these dishonest brokers will use high-pressure "boiler room" sales tactics to persuade investors to purchase stock.


Buying These Stocks
Two common fallacies pertaining to penny stocks are that many of today's stocks were once penny stocks and that there is a positive correlation between the number of stocks a person owns and his or her returns. Investors who have fallen into the trap of the first fallacy believe NESTLE, OANDO,FIRSTBANK, WAPCO, OCEANIC, ZENITH and many other large companies were once penny stocks that have appreciated to double/tripple digit values. Many investors make this mistake because they are looking at
the "adjusted stock price", which takes into account all stock splits. Rather than starting at a low market price, many of these companies actually started pretty high, continually rising until they needed to be split.

The second reason that many investors may be attracted to penny stocks is the conception that there is more room for appreciation and more opportunity to own more stock. If a stock is at N2 and rises by N1, you will have made a 50% return. This together with the with the fact that a N20,000 investment can buy 10,000 shares convinces investors that micro cap stock are a rapid sure-fire way to increase profits. For some reason, people think of the upside but forget about the downside. A N5 stock can just as easily go down N2.50k and lose half its value. Most often, these stocks do not succeed, and there is a high probability that you will lose your entire investment.

Conclusion
Sure, some pennies might be good quality, and many Second and Third Tier companies are working extremely hard to make their way up to the more reputable First Tier Securities. However, the flip-side is that there many good opportunities in stocks that are not trading for pennies. You need to understand that this is a high risk area that is not suitable for all investors. If you can not resist the lure of micro-caps, make sure you do extensive research and understand what you are getting into.