Penny stocks refer to companies whose shares trade between $1-$5.

Many penny stocks are considered micro-cap or nano cap companies. The classification is based these companies’ market capitalization. Typically companies with a market capitalization of between $50 million and $300 million is considered a “micro-cap” company. Those with market capitalizations of below $50 million, are often referred to as “nano-cap” companies.

Most penny stocks trade on the over-the-counter-bulletin-board (OTCBB) market and the pink sheet electronic quotation service. Penny Stocks can be very volatile and can see gains as much as 500% in a day.  But the volatility is a double edged sword, and many of these penny stocks come down as quickly as they go up.

What goes up, often comes down

A great example of this is volatility is Lithium Exploration Group (LEXG), which went on a wild ride in 2011. According to historical data from Yahoo Finance, LEXG opened at $1.20 per share on March 29, 2011. A month later, shares touched a high of $10.65 — that’s a 787% increase in a month!

But as quickly as LEXG rose, it fell. By the end of May 2011, shares of LEXG traded at around $2.50. LEXG’s closing price on December 30, 2011 was $0.54, according to historical data provided by Yahoo Finance.

How did this happen?

We don’t know. But there was a flurry of promotional materials about the company that was sent via e-mail and direct mail around the time the stock went bananas. Some penny stock investors view these promotional materials as research, or investment advice — something they should never do. Most of these materials were likely paid for by a third party, or in some cases the companies themselves. Paid-for “coverage” should always be viewed as an advertisement, and should never be considered credible research, or investment advice.

Where to look

Finding credible research on penny stocks can be very difficult. Most of these companies haven’t caught the eye of investment banks, and seldom receive research coverage from analysts. Although many micro cap companies file periodic financial statements with the SEC — some, particularly those whose shares trade on the pink sheets quotation service — don’t. Their lack of filings makes these companies especially risky.

Financial statements can provide great insight into a company’s history, current business and current financial condition, and should always be an important part of researching penny stocks.

According to Investopedia, you should spend about 20 percent of your time looking at financial results since many of these companies  aren’t making money yet, and 80 percent of your effort understanding the company’s business, people, market, and competition.

Here are a few other informational resources that may come in handy if you’re interested in learning more about penny stocks:

• OTCMarkets.com provides filings, news, and other information on more than 10,000 securities listed on the OTCBB and tiered Pink Sheet quotation service.
• Investopedia.com offers great primers and in-depth articles on various investing topics including penny stocks.
• Stockhouse.com has a great list of most actives, gainers and losers on the OTCBB and Pink Sheet quotation service
• This March 2012 article on Investopedia does a great job outlining the risks of penny stock investing
• A brief video on penny stock investing by  Phillip Beningoso

Disclaimer:

We are not registered investment advisors and are not qualified to give investment advice.  The content in this publication is for informational purposes only, and is not intended to be investment advice.