Penny Stocks and IPOs

Ah, the Siren’s call of a get rich quick idea. Anyone who has spent time researching stocks has no doubt been tempted by an ad somewhere for stocks rising 1000% in a week or share prices that skyrocket immediately upon a company’s listing on an exchange. The truth is that while these situations do occasionally happen, they are definitely the exception rather than the rule. Penny stocks and IPOs can be very tempting and perhaps in some cases can even be a good investment. However, the average investor does not have the time or the skill to properly research these types of investments.

Penny Stocks or Penny Shares

Stocks are considered to be penny stocks, or penny shares, if they regularly trade below about £3, though the definition varies. In the US market, shares trading below $5 are considered penny stocks. These equities do not usually trade on the major markets such as the London Stock Exchange, the New York Stock Exchange or the NASDAQ. Instead, they trade through smaller, less structured exchanges. In the UK, they may trade on the Alternative Investment Market, or AIM, or on the Off Exchange (OFEX). The US version of this is the Over the Counter Bulletin Board (OTCBB) or alternatively on Pink Sheets, which is a published quote system for over the counter (OTC) stocks.

Penny Stocks are Risky

There are a number of different reasons that penny shares are so risky, so let’s examine a few of the most pressing. One reason shares may trade at such low prices is because the company itself either is not profitable or does not have a proven track record of financial stability. Very solid companies with a strong financial history do not often need to trade over the counter. Instead, they will just be listed on the main exchange.

Less Strict Listing Requirements

One of the issues with researching companies dealt over the counter is that the listing requirements are often not nearly as stringent as they are on a larger exchange. For this reason, it may be difficult to get an accurate gauge on the company’s financial strength or even its potential.

Can Lose Considerably Overnight

The low price alone of penny stocks can lead to a number of situations where investors can get in trouble. With prices often at 50p or even less, one could purchase thousands of shares fairly easily with the hopes that the shares will rise quickly. After all, if a stock only cost 10p, it would only need to rise 10p to double your investment! The problems can multiply at this point. Without proper research, the shares may be just as likely to drop 10p as they are to rise that amount. Another problem is the exit plan. Too many inexperienced investors fail to make a proper exit plan or fail to execute it. Penny stocks are very volatile, meaning yes, they may rise 50% in a day or two, but if you do not jump on the opportunity to sell, or are not able to sell, they may fall just as quickly.

Liquidity Issues

One aspect affecting this volatility is the liquidity, or lack thereof, when it comes to penny shares. Because there are a limited number of investors trading these stocks at any given time, selling shares exactly when you want to may be difficult. In order to sell at a given price, you must find someone else willing to buy at that price. Failure to find a buyer may result in the price being forced down, therefore immediately decreasing your profit (if you were in a profitable position). Likewise, if you are selling because the shares are dropping in price, there is a risk of a price collapse if buyers are not willing to pay the price you desire.

Pump and Dump Scheme

The prices of these types of investments are sometimes driven by one investor with a large holding. Regulating bodies have tried to crack down on pump and dump schemes, but unfortunately it still happens. In this situation, the one orchestrating the scheme will artificially inflate the price of the stock, in which they already hold a significant position, by either paid recommendations or endorsements or by providing false information as to the value of the shares. Once the price rises, they sell their shares and the price drops back down.

Initial Public Offerings IPOs

When large companies decide to go public and list their shares on a major exchange, they first file for their initial public offering (IPO). As the time nears, the company will publish its initial stock price and investors may express their interest in shares. The shares must be purchased through underwriters, who are the stockbrokers that work with the company issuing the IPO. The underwriter helps determine pricing and then markets and sells the shares, raising capital for the company. This is a very difficult aspect of issuing an IPO and one of the reasons that they can be quite risky for investors.

How IPOs Are Valued

The value of a company during the IPO is determined using several factors. The underwriters use the company’s financial information, corporate structure and management, among many other factors to determine the price. The “many other factors” are very hard to measure. If the underwriter prices the shares too low, then the company is essentially leaving money on the table, because they only get money for the shares sold during the IPO. Once shares trade on the open exchange, these are not the company’s shares and the price is determined by the market.

True Example of IPO Volatility

One of the most infamous IPOs, and one that many point to when falsely giving hope to these investments, is that of Late in 1998, went public with their IPO priced at $9 per share. Once the stock hit the market, prices rose as high as $97 per share, finally closing the day at $63.50 per share for more than a 600% gain in one day. The following year, its shares were trading at under $.10 per share.

While that specific situation is unlikely to happen again, it does show the incredible volatility in IPOs, mainly because of so many unknown factors. These factors include things like public awareness and investor sentiment, which are nearly impossible to accurately measure.

IPOs Can Be Great Investments

This is not to say that IPOs are never a good investment. There are some excellent IPOs that come to market nearly every year. However, the fact is that the average investor simply does not have the resources to properly assess the risk and potential for reward. There will always be an aspect of chance involved in participating in IPOs. The key is to minimize the risk. The only way this is done is through knowledge and research.

Penny Stock and IPO Conclusion

For some, the potential reward offered by IPOs and penny stocks is just too great to pass up. If this article still has not scared these investors off, then maybe nothing will. The best advice one could take for investing in IPOs and penny shares is to learn as much as you can about the company in which you want to invest. Do not make emotional decisions – make an entry and exit plan for the position and execute your plan accordingly. Finally, and most importantly, do not commit a significant portion of your portfolio to risky investments such as these. It cannot be stressed enough that it is perfectly fine to invest a small amount of one’s wealth in high-risk, high-reward investments (with proper research). However, investors dedicating more than 10 – 20% of their capital in these types of investments are putting themselves in a perilous financial situation. Even successful high-risk investors should have safe money to fall back on. With that said, it can be very exciting, rewarding and even fun to research, plan and execute a high-risk strategy as a small part of a well-balanced investment portfolio.