Penny stocks are a much criticized investment option as a result of undesirable press they receive influenced by frequently unscrupulous activities that trouble the industry. Pump and dumps, the practice of artificially growing a stock price in order to sell stock for a higher price, is among the most well recognized tactic used by lots of penny stock owners and shareholders.
Such strategies are in fact present in every equity market, the unsightly effects on penny stocks are pronounced attributable to comparatively much less liquidity, poor investor sophistication as well as a lack of information.
And even though penny stocks are inherently more risky that larger cap stocks, like those listed on the NYSE and NASDAQ, it has to be remembered that a few of the largest sized companies listed in the United States were once considered penny stocks. There is no better example than Apple, which in 1996-1997 traded below $4. Now it is priced at at $420 and it is the largest company across the world by market value. Other examples of stocks that now trade above $25 but were once considered penny stocks include Green Mountain Coffee Roasters Inc, Netflix Inc, and VirnetX Holding Corp.
Micro cap stocks can provide for significant growth opportunity in one’s investment portfolio if you know what to look for.
First, doing your homework is important. Look at the industry the company operates in. Is it a growth industry? Can there be potential to expand in another country? What are the political or regulatory burdens this company faces?
It’s essential to take time to read through all the company’s SEC filings. This enables you to understand the business they are in, and how the company is performing now, and plans to grow in the future.
Seek out red flags. Has the business changed its name, ownership and industry over the years? Does the company rely considerably on related party transactions for its revenues, or loans? Has the CEO or senior management been the subject of an SEC inquiry?
In addition, you need to do research on the company’s management team. Do they have a record of running or growing companies? How suitable is their prior experience and education? A professional and trustworthy management team is a important factor when determining whether or not to invest in a penny stock.
Finally look closely at the company’s valuation. While it is normally expected that micro cap stocks have little sales, and/or high debt (especially start-up businesses), the value of the business should reflect this. When the value of the company isn’t consistent with its fiscal reports, and there’s no satisfactory explanation for this, there could very well be manipulation of the stock. In which case, avoid altogether.
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