What are penny stocks

Penny stocks are stocks priced at below $5 a share, and that usually have market caps below $500 million. The term originally referred to stocks priced below $1, but over time the threshold has risen to $5.

Some penny stocks are listed on exchanges, while others traded on OTC (over the counter) markets. In the US there are around 1,000 listed penny stocks and around 10,000 unlisted penny stocks. The first thing to know about these stocks is that unlisted stocks are not subject to the same levels of scrutiny and investors protection as listed stocks, and therefore carry more risk.

Finding Penny Stocks to Evaluate

To find listed penny stocks, you can use a stock screener like Finviz. Simply search for all stocks trading at $5 or less. For OTC stocks, you can use the OTC Markets Screener, which also allows you to specify the price range.

There are several ways to narrow the list down further to find stocks worthy of further evaluation. You can look at relative volume (the ratio of current to average volume), PEG ratios below 1.5, PE ratios below 15, or stocks with prices that have recently risen above their 20 or 50- day moving average.

We are now going to take three examples of penny stocks and look at the various resources we can use to find out more about the companies.

L & L Energy (LLEN)

L & L Energy was delisted from the Nasdaq in 2014, and now trades on the OTC market. In 2010 the stock traded as high as $14 a share, but by the time it was delisted the price had fallen to $1.66. Since 2015, the stock has traded between 1 and 2 cents, which may seem like a bargain when you consider the price it had traded at 5 years earlier.

Image Credit: Yahoo.com

However, you need to know what you are actually buying before you invest in companies like this. If you look up the stock on the OTC Markets website, you will immediately see the first red flag. The site includes warning that the company is not making material information publicly available.

Another good resource for both listed and unlisted stocks is Yahoo Finance. If you look at the financial data available for L&L Energy you will see that the last financial statements were posted in 2013. If you cannot find out anything about a company’s revenue, profits or debt (at the very least) you should avoid investing.

At this point you would probably want to avoid this company, but a little further digging would reveal that in 2015 the SEC sentenced the company to 5 years’ probation and the CEO was sentenced to a five-year prison term for securities fraud.

European Electric Metals (EVXXF)

In January 2019, the stock of European Electric Metals was heavily promoted on investor bulletin boards and using spam email and social media platforms.

This stock had many of the hallmarks of a pump and dump scheme, and after jumping over 30%, the stock price is now lower than it was before the rally.

Pump and dump schemes are coordinated actions by a group of traders to simultaneously promote a stock in the media and push the price up. This causes unsuspecting investors to believe whatever story they are promoting, and buy the stock. The promotors of the scheme keeping doing this as long as they can keep the price rising, before selling their own stock – which they bought before everyone else.

In the case of this company, you can very quickly see on Yahoo Finance, that the market cap is only $4.1 million which would make it a highly speculative investment. The company’s page on Yahoo finance also shows that the company has no revenue and the news over the last few months has not pointed to any sign of revenue in the near future.

If a stock is widely promoted, and the price rises on high volume, the first thing to look at is the news flow, and whether it justifies the move. Often pump and dump promoters will rehash old news or start speculative rumors based on non-material news.

Sequans Communications (SQNS)

In the case of listed companies, you will have more data to work, as public companies are required to publish certain information. Sequans Communications is a French semiconductor manufacturer listed on the NYSE and gives us an opportunity to look at some of the key ratios we should consider for small cap stocks.

Finviz is an excellent resource to quickly find key financial metrics. The following tables include some of the key ratios to look at when evaluating penny stocks and small cap shares.

We can immediately see that Sequans Communications is currently losing $34 million on sales of $45 million. So, the company is not profitable and needs to use shareholder funds to keep going. There are 96 million shares outstanding and the company has 5 cents of cash per share, or less than $5 million in total. This means the company will have to borrow more cash or sell new shares, which will dilute existing shareholders.

The debt to equity ratio of 6.89 shows that this business is already heavily leveraged and would struggle to borrow more. The quick ratio of 1.1 also shows that the company has just enough liquid asset to cover short term liabilities.

The profitability metrics show that the company has a positive gross margin, but it’s operating margin is -63%, meaning it has very high overheads and expenses. While analysts expect earnings to rise 40% next year, the long-term picture does not look great. In short, this company looks very risky and speculative.

Conclusion

Not all penny stocks are as risky as the ones described here, but a very high percentage are. That means you need to do a lot of research before considering investing in a penny stock share. In general, it’s best to stick to companies that are profitable, well capitalized and avoid stocks that are being promoted based on speculative stories about profits that might or might not materialize.