These penny stock definitions will give you insights into the risks and rewards of penny stocks

Some investors look to penny stocks as a quick way to boost their investment gains. To understand penny stocks better, we’ve compiled a short list of important penny stock definitions you should understand before investing in these risky ventures.

What are penny stocks?

A penny stock typically trades for under five dollars per share, and as the name implies, sometimes for pennies. Most of the time they’re young companies, or in speculative markets like mining exploration or early-stage technology, or some newly emerging business.

Buying penny stocks can lead to a big payday when you make the right choice. But the odds against success are high. Penny stocks are almost always involved in riskier ventures, such as finding mineral deposits that can be mined at a profit, commercializing unproven technologies or launching new software.

What’s more, it’s hard for any new company to grow into a profitable business, and it’s even harder in pioneering fields. But it’s relatively easy to launch a stock promotion that purports to have answers to social problems or ways to profit from emerging technology.

What are penny stock promoters?

Penny stock promoters are often part of the marketing department at a brokerage firm. Their aim is to build interest in the penny stock promotion. Most of the time penny stock promoters use ethical means to market and promote a penny stock but some use questionable tactics. 

Penny stock promoters love to make deals—however minor or indirect—with major, big brand companies. They use these deals to build trust with the public. They’re convinced the public is far more likely to buy penny stocks that have these partnerships in place.

Major company involvement is frequently exaggerated: When penny stock promoters manage to make a deal with a major firm, they often go to great lengths to make it seem bigger than it is. Instead of announcing that the big company has invested, say, $50,000, a penny stock promoter may issue a press release saying the two companies have entered into a “multi-stage development plan.” The release may say the major company has agreed to spend “up to $10 million” or some other exalted figure. It will usually provide a toll-free number or web address for investors to order or download the glossy brochures.

What is a penny stock promotion?

A penny stock promotion is launched by penny stock promoters. Penny stock promotions are created to make a penny stock appear more valuable than it actually is, because it’s much easier to launch a penny stock promotion than it is to create a successful, lasting business.

Penny stock promotions often include household names because penny stock promoters have an easier time selling a penny stock when a major mining company has agreed to finance exploration of their mining claims, or if a household-name multinational has agreed to evaluate their revolutionary software or “cloud” application.

When they get a deal with a major, penny stock promoters go to great lengths to make it seem bigger than it is. In fact, when a penny stock shoots up on the news of big-company involvement, and the property/program/revolutionary software is still in the early stages of development, it’s often a good time to sell.

What are speculative investments?

Penny stocks are often considered speculative investments. A speculative investment is typically an investment in a new company without a history of revenues or profits—or successful sales to customers or development of a mineral property and so on.

We do sometimes recommend speculative investments that have not yet begun making money, mainly in our advisory for more aggressive investing, Stock Pickers Digest. As long-time readers know, we have had some standout successes, including speculative investments taken over at a rich premium.

When a speculative investment is losing money, it has a great deal of freedom to ponder on its future. With a little imagination, it can always show that anything’s possible, based on a logical series of events that it says will take place as it advances inevitably toward profitability. Meanwhile, it doesn’t need to worry that its price-to-earnings or p/e ratio is too high, since it doesn’t have one—it has no “e”.

When a former money-loser finally starts making money, however, the handcuffs go on. Suddenly this speculative investment has a p/e, probably one that is sky-high. Inevitably the killjoys (like us) then start calculating how fast it needs to grow to justify its current stock price, let alone go higher.

Because speculative stocks expose you to a greater risk of loss, we recommend limiting your speculative investments to no more than, say, about 30% of your overall portfolio. That number can vary. Ultimately, this percentage depends on your personal circumstances and risk tolerance. An investor with a longer time horizon or without the need for current income from a portfolio can invest more money in speculative stocks. But we think 30% is a good rule of thumb.

Advice for investing in penny stocks

Main factors to look at when seeking penny stock success

• We insist on political stability. For example, mineral exploration is risky enough without the threat of expropriation or onerous taxes.
• We look for well-financed penny stocks with no immediate need to sell shares at low prices, since that would dilute the interests of existing investors.
• We like to see a strong balance sheet with low debt. Even better, we like to see a major partner who can finance the mine, software and so on to production.
• We want to see experienced management with proven ability to develop and finance a new business.
• We avoid stocks trading over-the-counter where regulatory reporting and so on is lax.
• We avoid stocks trading at unsustainably high prices due to broker hype or investor mania.
• We compare the market cap of the stock with the estimated value of its mineral reserves, future product sales and so on. Some pennies need to find a mine, or successfully market a lot of their software, or other products, to justify the current share price and avoid collapse.

Follow our three-part Successful Investor strategy

Limit your risk with penny stock investments by investing following the tips we mention above. Also, for your total portfolio, follow our three-part Successful Investor strategy:

• Invest mainly in well-established companies;
• Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
• Downplay or avoid stocks in the broker/media limelight.

What additional advice or feedback would to add to this article that would help potential penny stock investors?