What are penny stocks?

The risks of trading penny stocks
The risks of trading penny stocks

New investors are often attracted to penny stocks due to the large opportunity for profits they seem to present. "If the shares can just trade up from $0.10 to $0.20 each, I'd double my money" is a popular line of thinking.

But penny stocks are far more dangerous than buying large, well-established companies. The penny stock universe include shares of failed companies, occasional frauds, and schemes intended to transfer money from the greedy newbie to their motivated, if unsavory, operators.

For example, the actual Wolf of Wall Street case involved peddling penny stocks.

The history of penny stocks: Before electronic trading and discount brokerage firms, penny stocks got a bad rap for being prohibitively expensive. In the old days, you'd pay as much as a quarter-point ($0.25) to buy or sell a share of stock.

This was the brokerage firm's commission. And because it was set in stone -- it didn't matter whether a share traded for $1 or $100 -- the commission made up a much bigger portion of your investment in penny stocks than it did on pricier shares.

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Many mutual funds enacted policies to avoid stocks which trade for less than $5 per share for reasons of expense (they pay commissions, too) or because of their speculative nature. And over time, it just so happened that the feeling became something of a self-fulfilling prophecy. People avoided penny stocks, and thus it became generally accepted that only the worst companies would let their shares trade at penny stock prices.

Penny stocks today: The widely accepted definition of penny stocks has been somewhat extended to cover other, higher-priced stocks which also trade in less-regulated, over-the-counter markets.

Over-the-counter stocks are generally less liquid, and they have fewer requirements to remain listed. Many don't even file financial reports on time, or at all. And they're often managed by people with a less-than-stellar pedigree.

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Conflicts of interest are probably the most common issue. I've seen it all over the years -- from company-owned planes that are used more for the executives' pleasure than business, to companies that pay above-market rents because the CEO just so happens to also be the landlord.

That isn't to say that these bad behaviors are inherent in penny stocks, just that they're more common. One of the benefits of obscurity is that some managers can get away with a lot more without the benefit of prying eyes looking over their every financial filing.

Should you buy penny stocks? If I were to paint with broad strokes, I'd recommend avoiding them entirely. There are, however, legitimate companies that happen to have low share prices. AMD (AMD), a company which makes many of the chips in electronics ranging from laptops to phones, has long traded for prices in the penny stock range of less than $5.

Likewise, Roche Holding (RHHBY), a Swiss health care company many would recognize, has shares listed on the over-the-counter market to allow American investors to invest in it.

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AMD and Roche are legitimate businesses. They file regular financial reports, adequately disclose their business lines to investors, and are clearly not illegitimate companies. They just happen to have a single trait of most penny stocks -- a low per-share price or an OTC listing.

Many penny stock and OTC-listed companies are nothing more than shells. They include the likes of marijuana companies, some of which exert more effort to market their stock than their products, and "dark" companies that haven't filed financial statements in years.

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A large number (by my count over 40%) of OTC stocks are considered "grey market" stocks, which do not require any filings with the Securities and Exchange Commission. Can you imagine investing in a business, having no idea what it earns, or even what its business model entails? That's the case for nearly half of stocks that trade over the counter.

Though they may seem like an easy and simple way to quick profits, know that penny stocks are anything but. The "easy" way to get rich in stocks is to buy good businesses and own them for a very, very long time -- years, if not decades.

Investors dominate the list of Forbes 400 billionaires, but I can assure you it wasn't penny stocks that created their wealth.

Jordan Wathen is a value investor who writes for The Motley Fool. The views expressed here are his own.

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