What are penny stocks?
There is no set, accepted definition of penny stock. Some people define it as stock priced under one dollar, some under five dollars. Some people include only those securities traded in the “pink sheets”, some include the entire OTC market. The Securities Division considers a stock to be a “penny stock” if it trades at or under $5.00 per share and trades in either the “pink sheets” or on NASDAQ. In addition, a true penny stock will have less than $4 million in net tangible assets and will not have a significant operating history. (In other words, if a company has real assets, such as equipment and inventory, and is engaged in some real business, such as manufacturing, then the Division does not consider the stock to be penny stock even though the shares are low-priced.)
The “OTC”
Penny stocks are not traded on a stock exchange market but are traded in the over-the-counter (OTC) market. Part of the OTC market is the NASDAQ National Market (NNM) of the NASDAQ National (Association of Securities Dealers Automated Quotation) System, which does not include any penny stocks. There are also non-NNM NASDAQ securities, including some penny stocks. The NASDAQ system has listing standards that change from time to time and, depending on the standards, there may be more or fewer penny stocks on NASDAQ. If you purchase a low-priced security that is listed on NASDAQ, it will meet certain minimum standards. In addition, many NASDAQ prices are quoted regularly in newspapers, allowing you to follow the price of your security instead of forcing you to rely on your broker for all price information. The third major component of the OTC market is the National Quotation Bureau’s (NQB) service, commonly referred to as the “pink sheets”. The NQB’s securities lists and price information, printed on pads of long, narrow sheets of pink paper, have, for all practical purposes, no meaningful listing standards, and price information is sometimes difficult, if not impossible, for the small investor to obtain. Broker-dealers obtain their price information by calling the trading desks of three “market makers”. Obviously, small investors do not have access to those traders and must rely on their stockbroker for accurate price information.
Principal/Agency
In most securities transactions, your broker-dealer Agency acts as your agent, arranging a transaction directly between you and a third party. In compensation for arranging that trade, you pay your broker-dealer a commission. In some instances, the broker dealer has the security you seek to purchase in inventory, or wants the security you wish to sell. The broker-dealer may trade with you on its own behalf, as a principal in the transaction. When the broker-dealer acts as a principal, and not as an agent, the trade confirmation should say that on its face. The broker-dealer is not paid a commission in principal trades, but makes its money on the spread, and by buying and selling at advantageous times, the same as any other investor. A sizeable portion of penny stock trades are principal transactions, and an investor should be alert to the potential conflicts of such transactions.
Bid/Ask
Penny stocks do not each have a single price at which they are bought and sold, but a number of different prices. The first difference is between the bid price and the ask price. The bid price is how much someone is willing to pay for the security, or the price at which you could sell your shares. The ask price is how much someone will sell their securities for, or how much you will have to pay. The difference between the prices is the spread.
The spread
To most investors, the spread represents a built-in loss at the time of investment. For example, if you purchased a stock that traded at 1/2 cent bid, 1 cent ask, the bid would have to more than double in price for you to break even (the “more than double” comes from additional costs such as “ticket” charges and other miscellaneous costs). Many investors buy penny stocks believing that “trading at 12½ cents” means that they can buy and sell at 12½ cents. This simply is not the case, and any salesperson who uses such a phrase is only telling half of the truth. The spreads in penny stocks are most commonly 25-33%, are often 50-100% and sometimes are over 100%. Another factor to keep in mind when evaluating price information about penny stocks is that there are two “bid” and two “ask” prices, the inside and outside bid and ask. As a general rule, the price you will be interested in will be the outside bid and ask, or the lower bid and the higher ask, as those are the bid and ask prices to public customers.
Mark-ups
The last pricing factor concerning penny stocks is called the mark-up. A broker-dealer who has held the security in its account and subject to the risk of market price fluctuation, may mark the price of the security it sells to you up by a certain percentage, on top of the spread. This is to compensate broker- dealers for maintaining inventory sufficient to supply demand for an orderly and liquid market. What it means to the average investor is another cost that creates a built-in loss at the time of investment. In other words, the instant your transaction is effected, your securities are worth less than you paid for them. Although it is no guarantee of a good price, you are more likely to get a better price in an agency transaction using a broker-dealer that has no interest in the transaction, due to the pricing factors above. In the typical penny stock transaction, the broker-dealer buys from its customers at the bid and sells at the ask, capturing as compensation the spread, plus any mark-up.
Market Makers
A market maker is a broker-dealer who stands ready to buy or sell 100 shares of the stocks in which it makes a market. When a transaction is proposed, the market maker will give a price at which it would be willing to effect that transaction. The market maker’s price applies only to the first 100 shares. While the market maker system has been widely criticized (after all, how much of a commitment is it to buy 100 shares at a penny apiece?) the system does offer investors some level of fairness. The more market makers there are in a given stock, the more likely they are to bid against each other, and the price will more likely move to a true “market” price. The names of the market makers of securities traded in the pink sheets are listed in the pink sheets.
Initial Public Offerings
Stocks are introduced into the market through an initial public offering (IPO). In most cases, an IPO would need to be registered with the Securities Division, which applies a set of guidelines to the offering to determine whether the offering is “fair, just and equitable”. Fraudulent offerings are rejected and not granted registration.
Legitimate Penny Stocks
There are legitimate companies whose securities trade in the pink sheets at very low prices. Struggling young companies just starting out are perfect examples. Investment in such a company, held through the company’s formative years, can pay off well. Such an astute investment requires three things: the ability to choose the right company, the capital to invest and hold the investment, and persistence. If you find the right company, you must be able to hold the investment for years to allow the company to mature and for the stock to appreciate in value.
Sources of Information
The prospectus is the most comprehensive source information about an IPO. It sets out where your investment money will be used, describes the capitalization, history and management of the company and describes the cash flow system of the company. Trade confirmations contain a wealth of information. The confirmation will show basic information, such as number of shares, but will also indicate whether the transaction was agency or principal, was solicited or unsolicited (it will say “unsolicited” if you called your broker to place the order without your broker having tried in any way to get you to place the order) and, in the case of most pink sheet and non-NASDAQ National Market trades, provide the bid and ask at the time of execution of the transaction. Websites and Investor relations companies that have credibility. Manuals such as Moody’s and Standard and Poor’s have current financial information about companies, and most penny stocks are listed in the manuals. Periodic reports filed with the U.S. Securities and Exchange Commission have updated information about companies that register with the SEC. The most common report is a “10-K”.
