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By Joanne Sommers
Stockhouse.com
Thursday, September 28, 2006
"You have to dig much deeper for information on penny stocks," says Irwin Michael, the head of Toronto-based I.A. Michael Investment Counsel Ltd. "But because the average person doesn't have the necessary financial and research capability, it's often treacherous to invest in these companies."
Adrian Mastracci, Portfolio Manager at Vancouver’s ‘fee-only’ KCM Wealth Management, says, "Vigilance is the watchword when it comes to penny stocks. Approach them cautiously because many have a habit of blowing up."
Or, as the SEC website bluntly states, "Investors in penny stocks should be prepared for the possibility that they may lose their whole investment."
In addition to the lack of readily available information, another problem is limited liquidity. Since penny stocks trade fewer shares each day than larger companies, any sudden change in supply or demand can send prices soaring-or crashing. Lack of liquidity and price volatility also make penny stocks much more vulnerable to manipulation. And illiquidity can make it difficult, if not impossible, to sell a stock on any given day.
Another major concern is accountability. Most penny stocks trade in the over-the-counter (OTC) market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the "Pink Sheets." Companies that trade on major exchanges must meet listing standards, such as a minimum amount of net assets and a minimum number of shareholders. In contrast, those on the OTCBB and the Pink Sheets are not required to meet any minimum standards.
OTCBB companies must file updated financial reports with the SEC or with their banking or insurance regulators. When an OTCBB company fails to comply, the letter "E" is added to its four-letter stock symbol and the company has 30 days to file with the SEC or 60 days to file with its banking or insurance regulator. If it remains delinquent following the grace period, the company is removed from the OTCBB. A list of such securities is available at www.otcbb.com.
"If the NYSE is the Cadillac and Nasdaq is the Lexus of stock exchanges, the bulletin boards are the thrift shop and the Pink Sheets are the trash that people leave on the curb," says James Angel, an associate professor of finance at Georgetown University, who specializes in securities markets. "You need to do your homework very carefully. If you're lucky you might find some gold nuggets but most of it is fool's gold."
Transaction costs are higher on the OTCBB and the Pink Sheets, he notes, adding that there are wider bid-ask spreads (the amount that the ask price exceeds the bid) and greater volatility than on the major exchanges.
Angel recommends prudence when it comes to the Pink Sheets, which, he says, "will trade anything that looks like a stock, including companies that can't file with the SEC." Enron, for instance, traded on the Pink Sheets for about five cents a share for nearly a year after the company went bankrupt, despite the fact that the shares were worthless. "And after United Airlines went bankrupt, it traded on the OTCBB for more than $1 a share for a year."
Such examples-which Angel puts down to "consumer stupidity"-highlight the need for extreme caution, adding that two excellent sources of information are www.pinksheets.com, whose "company filings" link takes you to financial statements, and www.knobias.com, which provides information about companies that trade in the OTCBB and Pink Sheets.
Vigilance is the watchword when it comes to penny stocks, according to Adrian Mastracci, investment counsel at KCM Wealth Management in Vancouver.
"Approach them cautiously because many have a habit of blowing up," he says. "They can move very quickly so limit orders don't work. You have to watch the market at all times or you may get stuck with a bust."
Mastracci also warns that penny stocks are hard to buy on a discount account, "and you may have to deal with a broker who specializes in smaller companies." What's more, "you can't buy in small quantities because commissions can represent a significant percentage of the purchase price."
Penny stocks, however, can be a good teaching tool. "They're a good way to learn how to take capital losses," Mastracci says. "The hardest thing for investors to do is to sell at a loss and this is one place to cut your teeth on that."
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