Penny stocks trade for five dollars or less per share, which makes them seem like a very attractive investment. However, the amount of risks involved in owning penny stocks have caused some to refer to them as the equivalent of playing the slot machine. That is not to say that everyone should steer clear of them because they can actually make a nice addition to the investment portfolio as long as the investment decisions are made wisely.
Individuals should understand why these investments are considered risky before sinking money into them. Penny stocks are considered the most manipulated and volatile form of investment available on the market. Some of the companies they represent do not have any history of good financial performance. These stocks are also sometimes manipulated by scammers. These swindlers drum up hype in the next “big thing” and get people to invest, driving up the stock price, then sell when it peaks, and get the heck outta Dodge. The unknowing investors are left holding worthless stocks.
Before investing in penny stocks, new investors should gain at least a year of experience with mid-cap and large-cap stocks. They should understand the way the stock market operates and learn how to read income statements, cash flow statements, and balance sheets. During this time, they should also learn more about the traits of penny stocks that could cause positive or negative impacts on the investment portfolio. This involves understanding terms like market capitalization and cash flow and what each entails.
The investor can then begin reviewing available penny stocks and narrowing down the list of potential investments. Those that are traded over the counter or on a bulletin board should be eliminated. In general, companies in unknown or disliked industries and those with less than a $10 million annual revenue should also be dropped from consideration. Perhaps most importantly, any company that is recommended in a penny stock trading email should immediately be crossed off the list. These emails are usually part of the scams mentioned above.
Investors should seek companies that consistently generate cash and have increased cash flows. They should compare the price per share to the book value per share, or assets less liabilities, rather than simply looking at share prices. Investors should then buy companies at under six times their cash flow and limit the amount of penny stocks to fewer than five percent of their portfolio.
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