Top Reasons to Avoid Penny & Micro-cap Stocks

by Adam Jones | Last Updated: April 23, 2020

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Penny & micro-cap stock investing is not for the faint of heart. In fact, the majority of inexperienced investors end up losing tons of money. If it is too good to be true, it likely is. Never make an investment based on hype unless you mentally prepared to sell quickly and lock in profits. 

Learn it from a pro who lost his money when I first started. Yup, from hero to zero. I’m going to try to convince you why not to invest in these high-risk stocks. 

man regrets not avoiding penny & micro-cap stocks

Remember in the investing world, appearances are quite deceiving (at least majority of the time). Your stock may skyrocket at first. However, the next minute you lose your shirt, shorts, and shoes in the blink of an eye. Just like that, your savings is wiped out. So the key question is how does this happen? 

1. Fraud

Top on the list of reasons not to invest in penny & micro-cap stocks is fraud. It is much easier to cook the books because there are far less stringent requirements on the exchanges these stocks typically trade on. Therefore, many of these companies don’t have an external auditor, post financial reports, or hold conference calls. There are few analysts following the company as well to raise red flags to investors. 

2. Pump and Dump Schemes

Micro-cap stocks that show big gains in a short period are due to pump and dump schemes. The company, insiders, or investors typically will pay stock promoters to create excitement and buzz around the company. Stock promoters send emails to their subscribers who in turn buy shares of the company causing the price to increase quickly. Next, the company or insiders sell shares for a profit. After this, the stock price usually plummets and the scheme leaves inexperienced investors wondering what happened and how they lost their money. 

3. Price Manipulation 

Penny and micro-cap stock manipulators buy lots of shares of the stock with a low share float. The manipulators make sure to purchase the stock over a long period of time so it doesn’t cause the price to spike. Next, they hold the shares as the price increases so there are no sellers causing the price to increase quickly. Finally, the stock manipulator will sell his or her entire position.

4. Low Volume  

Often penny and micro-cap stocks only trade a small amount of shares every day making it hard to exit your position. Lets say a stock is trading at $0.01 and 10,000 shares are traded per day. This means $0.01 x 10,000 = only $100 worth of shares are bought and sold each day. If you had bought $1,000 worth of shares it would take you about 10 days to sell all of yours shares. Stick with high volume stocks so that you can easily exit your position if needed. 

5. Limited Public Information 

Stocks listed on lesser exchanges have significantly less reporting requirements. Therefore, it is likely that the stock won’t even post quarterly or annual financial reports. This makes it difficult to find information on the company or the health of the company. In addition, it is highly unlikely the company will hold quarterly conference calls. It can be very difficult to do extensive research on a company to determine its potential to succeed. You can use a micro-cap stock screener to help weed out companies that aren’t profitable or post little information.

Why do Penny & Micro-cap Stocks Trade on Pink Sheets or OTC?

Generally, penny & micro-cap stocks cannot meet the stricter requirements of senior exchanges like the NASDAQ & NYSE. These requirements often include independent board members, external auditor, regular filings of financials, and conference calls among other things like market capitalization and share price. We recommend a large degree of caution when investing in stocks that trade on pink sheets or over-the-counter markets.

Why Do People Invest in Penny or Micro-cap Stocks

A lot of people are drawn to investing in penny and micro-cap stocks because the price increases quickly over a very short period of time. In a matter of a few days, a stock might go from $0.10 to $0.80. This is very exciting and the appearance of getting rich quickly. An inexperienced investor thinks, “If I put $5,000 it would turn into $40,000 in only a few days! If I do this a few times, I’ll become a millionaire.”  This is a scenario that is too good to be true, and make no mistake about it.  

The likelihood of being able to invest $5,000 into a penny or micro-cap stock would be difficult. Even more difficult will be trying to sell your shares without causing the stock price to decline. Remember for every share you sell, there needs to be someone that buys those shares from you. Even if the price goes to $0.80, there may not be any buyers at that price level. 

Unlike stocks like Apple or Tesla, which enjoy significant share volume, some of these penny and micro-cap stocks have very few buyers and sellers.

An Example on How This Could Happen

Let’s go through an example to illustrate this point. For the sake of being generic, the ticker symbol and company has been removed. You wish to invest $5,000.

Market Capitalization: $5.20 million
Current Share Price: $0.10
Day’s Range: $0.10 – $0.80
Average Daily Volume (90 days): 5,000

If you tried to buy shares at $0.10 and tried to sell them at the end of day for $0.80, it would have been impossible. First, the share turnover only allows for $500 ($0.10 share price x 5,000 average volume) worth of stock to be bought and sold. Nowhere near the $5,000 you want to invest. There would not be enough sellers to sell you shares. Similarly, if you had bought $5,000 of the stock you own 50,000 shares. Thus if you try to sell at $0.80, it would be near impossible as there aren’t enough buyers given the average daily volume. 

How You Should Invest in Micro-Cap Stocks

The best way to have exposure to micro-cap stocks is through the iShares Micro-Cap ETF. It tracks the Russell Microcap(R) Index and consists of 1,300 different companies. This will allow you to diversify appropriately. 

Investing in individual micro-cap stocks needs to be done with extreme care. Given all the risks and reasons to avoid penny & micro-cap stocks, gain some experience before diving in. Therefore, make sure to learn how to invest in micro-cap stocks before putting real money to the test. 

It is best to practice before you invest with your own money. This can be done through free paper trading tools. These simulators allow you to test your trading strategies. Thus you can learn what works and what doesn’t. Do this over a couple of months and you will be less likely to lose lots of money. 

What are Penny or Micro-Cap Stocks

Penny stocks are stocks that trade less than $5.00 according to some institutions. However, many people denote penny stocks as stocks that trade between $0.01 and $3.00. A micro-cap stock is a company that has a market value between $50 million and $350 million. A market value is determined by taking the share count multiplied by the share price.  

Oftentimes, penny and micro-cap stocks have little to no profits, minimal revenue, and small operations (if any at all). Most essentially are shell companies with old business that have failed. They almost always trade on pink sheets or OTC exchange unlike more senior exchanges like the NYSE, NASDAQ, and S&P 500. 

Large companies and even former blue-chip companies share prices can fall becoming penny or micro-cap stocks. This happened during the Great Recession in 2008-2009 and during the Coronavirus Crisis. Many financial sector mega-caps became penny stocks (Bank of America, Citigroup, and many others). Several stocks underwent reverse stock splits to avoid their stock prices from becoming penny stocks.

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