To avoid scams, Asher Rogovy, chief investment officer at Magnifina LLC, emphasizes the importance of thoroughly researching the companies you’re interested in.
Rogovy, too, stresses caution. “It’s certainly appealing to think your stock may increase to 10 times its value, but this is exceedingly rare. If an investment seems too good to be true, it probably is.”
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“There aren’t many success stories about investing in penny stocks. Their appeal is understandable: perhaps there is some company trading at pennies which may increase in value by 10x or more. However, this is exceedingly rare and the old wisdom about “too good to be true” often applies. Investors are also drawn to penny stocks because they appear more affordable. Now that several brokers offer fractional share trading, there’s no good reason to pick stocks simply because of the single share price.
Looking at a stock’s market cap (i.e. the total price of all the shares) is more helpful. It might be better to think of “penny stocks” as “microcap” stocks instead. When analysing these companies, it’s important to figure out the reasons behind a company’s value. For most microcap stocks I’ve looked at, the company went public but its business eroded until just the corporate entity remains. These “zombie companies” have some value in that they are already listed on exchanges. Private companies looking to go public may avoid the costs of an IPO through something called a “reverse takeover”. This is especially popular with foreign companies looking to list themselves on US exchanges.
Nevertheless, there is still significant value in analyzing microcap stocks to search for genuinely distressed equities. These would be viable businesses which have fallen on hard times, but retain a path to recovery. Indeed, some investors specialize in identifying these rare companies and the profits can be extraordinary. A great example is Mortgage Guaranty Insurance Corporation (MTG) in 2012. Their mortgage insurance business had been decimated by the subprime mortgage crisis, and almost went bankrupt. However, the company recovered, and the stock rallied over 1000% in 5 years. MTG was only technically a penny stock for one month 2012, but it remained a microcap stock for several years. Even when the price was $2.00, it vastly outperformed countless other stocks during the same period. That’s why limiting analysis to prices below $1.00 may miss some great opportunities.”
Quote altered with permission