My daughter has had her job after university graduation deferred for two months, so she has some spare time. This week she asked me to teach her how to day trade or, alternatively, how to trade

penny stocks

. After I picked myself up off the floor, I decided to teach her why she shouldn’t do either of these things if she wants any chance of investment success.

Long-term trading

beats day trading

, so let’s take a look at five reasons why trading penny stocks is a fool’s game for any serious investor. We will consider penny stocks as any small, highly risky, highly speculative stock, regardless of its actual share price.

Many small companies consolidate their shares just so they are

not

penny stocks. But they are not fooling anyone. A tiny company with a $3 share price can be just as ridiculously risky as a tiny company with a 15-cent price.

Lack of transparency

Penny stock companies are often not required to disclose the same level of financial or business information as companies listed on major exchanges. This lack of transparency makes it difficult for investors to perform adequate research or to assess the true value and health of the business, increasing the ris of loss.

Accounting regulations can be lax, especially with over-the-counter (OTC) or Chinese companies. The OTC market actually uses a skull-and-crossbones symbol to alert investors of the higher risk of some of its listed companies. Do you really want to buy a stock where the regulators of the exchange utilize the poison symbol to warn you off investing in it?

High volatility and illiquidity

Penny stocks have low trading volumes and liquidity. Often, controlling shareholders own 90 per cent of the stock’s float, so that any buyers have to pay ever-increasing prices to establish a stock position. This means that even small trades can have large effects on the stock price, making them extremely volatile and difficult to buy at a decent price.

Even worse, of course, illiquidity makes it even harder to sell at a desired price. And, trust us, if you find yourself owning one of these penny stocks, you are going to want to get out at some point. Movements of 50 per cent or more can be common occurrences. Investors may find themselves completely unable to exit positions without accepting a steep loss or may be stuck holding the bag if buyers suddenly disappear.

Susceptibility to manipulation and fraud

The combination of tight floats, low liquidity and low regulation makes penny stocks especially prone to market manipulation such as pump-and-dump schemes. Corrupt management and promoters can artificially drive up prices, attract unsuspecting investors and rapidly sell out, causing prices to collapse and major losses for those left holding shares.

Don’t believe us? There was

once a company

that at one point was worth $10 billion. Its business? Searching for Bigfoot We can’t make this stuff up. Or, more recently, seven Nasdaq-listed micro-cap stocks — Concorde International Group Ltd., Ostin Technology Group Co. Ltd., Top KingWin Ltd., Skyline Builders Corp., Everbright Digital Holding Ltd., Park Ha Biological Technology Co. Ltd. and Pheton Holdings Ltd. — all dropped more than 80 per cent in a matter of weeks in July after first being pumped up and heavily promoted on social media sites.

Poor business fundamentals

Most penny stock companies have unproven or failing business models and weak financial health. Many are on the brink of bankruptcy, engage in creative accounting or have no sustainable plan for growth. The vast majority of these companies eventually go out of business or become worthless.

The first rule of investing is to “buy quality,” and, frankly, we have never in our 40 years in the business seen much quality in the penny stock arena.

Costs of simply being public

Would you buy an exchange-traded fund with a nine per cent expense ratio? Of course not. But a tiny company listed on an exchange has very high expenses just to maintain being public. There are listing fees as well as lawyers, accountants and regulators to pay.

The cost of being public can vary with the exchange, but can typically run to $300,000 or more annually. Yet, there are hundreds and hundreds of penny stock companies out there with market capitalizations of $2 million to $4 million. A $3-million company, then, might be paying 10 per cent of its entire market cap just to be public. This expense will impact the company every single year, regardless of its success or lack thereof.

Typically, ongoing expenses and losses result in continuous share issuance and dilution at tiny companies. This expense drag is a huge impediment to investment performance and shareholders suffer as a result.

Overall, penny stocks are highly speculative, poorly regulated and more likely to result in significant financial losses rather than gains for most investors. We know, of course, why they still exist: g

reed

.

  • 5 reasons investors like dividends
  • 5 things it would take to get small cap stocks moving again

But the next time you find yourself tempted, take a look at the reality and risk of what you are considering buying. With even five minutes of research, you might realize you are not buying quality.

Peter Hodson, CFA, is founder of 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)

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