Why Penny Stocks Are Bad Investments

You have probably read or heard someone express the following sentiment: “I enjoy investing in penny stocks. It seems so easy to make money quickly because it is so much easier for a stock to go from $0.25 to $0.50 instead of $50 to $100.”

More experienced investors can recognize the logical fallacy in this. Regardless of a stock’s per share price, any doubling of the stock requires a doubling of the market capitalization (unless there are stock buybacks). If General Electric (GE) stock rises from $31 to $62, it is because the investor community thinks that General Electric is worth $560 billion instead of $280 billion. Likewise, for Rubicon Technology (RBCN) to go from $0.62 to $1.24, the valuation of the business must go from $15 million to $30 million. Both shifts require a 100% increase in market value.

A lot of people probably look at Berkshire Hathaway’s A shares trading at $244,000 and think it “must be overpriced.” Well, no. Berkshire makes $24 billion per year in profits. Each share of Berkshire A shares is representative of almost $14,000 in annual profits. If Berkshire went into cash cow mode and paid out all of its earnings as dividends, the $14,000 you’d receive from the Berkshire A share would represent the maximum gift allowance you’d be permitted to give someone in 2017.

Meanwhile, others probably look at a stock like Altria trading at $67 per share and yielding 3.6% and conclude: “It must be cheaper than those $244,000 Berkshire shares.” Nope. Altria makes $3 per share in profits, putting the valuation at a historically high 22x earnings for the tobacco stock.

The reason Berkshire’s stock price sounds so high is because Warren Buffett only wanted to divide its entire conglomerate into 1.6 million pieces. The management team at Altria, meanwhile, has chosen to break up the ownership of its tobacco business into 2 billion pieces.

When I first started studying investing, I built a spreadsheet that equalized every stock into $100 blocks so that I would not give into the cognitive bias of thinking that higher stock prices automatically meant that a stock was more expensive. It was my way of trying to neutralize the arbitrary decision each corporation makes about how many shares to slice the business up into so that ownership can be freely transferable, liquid, and marketable.

If I built that chart for Berkshire Hathaway, it would say this: “Every $100 you invest into Berkshire Hathaway gives you a claim on $5.71 in current profits that are growing at 10% per year and none of those profits are being shared with you as a dividend.” If I performed the same exercise with Altria, it would say that “every $100 you invest into Altria gives you a claim on $4.48 in current profits that are growing at 7.5% per year and $3.50 of those profits are being shared with you as a dividend.” When you study investments this way, share count bias is eliminated.

Eventually, you will outgrow this and be able to make the conversion automatically. It is sort of like when you first start studying a language, you translate each Spanish word into English for processing and then think up your answer in English before translating it in your head back into Spanish. Years later, you find yourself actually understanding the Spanish language and processing information you hear without the need to translate it in your head back to the native tongue.

You might wonder then: Why am I biased about penny stocks? If the price of a stock is a function of how many shares a management team arbitrarily chooses to slice up the ownership position in the position, why should a management team that chooses a high enough share count to drive the price of the stock below $1 be disfavored? Isn’t discrimination against a penny stock investing strategy an example of the same cognitive bias I just warned you against? Again, no.

When a business decides to incorporate, it must include a par value for the stock authorized for issuance in its articles of incorporation. Typically, the par value is $1. Par value tells you nothing about the stock is worth, but instead, is a legal binding promise from the corporation to never sell new shares of stock at a price below $1.

The reason corporate management teams pick such a low par value for the stock is because the par value is used for the minimum capitalization for the stock of the business and is used to calculate state filing fees as part of incorporation, and also, corporate management teams like to give themselves as much latitude as possible to hypothetically issue stock—why would you go around setting par value at $50 if that meant you had to pay a higher filing fee and you would cut yourself off from the right to ever issue new shares of stock at a price of $49.99 or lower? Smart managers don’t usually go around giving up some of their legal rights without anything being given to them in return for doing so.

As a practical matter, what does this imply about those who want to purchase stock that is selling for less than a dollar?

Prior to the time you have purchased the stock, the investor community has devalued the stock so substantially that it is being traded at nearly insolvent levels. The management norm is to create a corporation in which shares are initially sold at a price of $10 per share. If the stock qualifies for penny status and is trading at less than a dollar, this means that the stock has already fallen by at least 90% in value. When a business goes from that $10 range to less than $1, the penny stock limbo is the final step before bankruptcy in which your investment is entirely wiped out.

In addition to the 90% stock price fall, the fact that a corporation is trading at less than $1 usually means that the management team is prevented from raising capital by issuing new stock. If a stock is trading at $0.30 per share, and if the par value is $1, the management team has entered a contract with the state of incorporation (usually Delaware or the state where the decision-makers reside) to never issue new stock at a price below $1 as a condition for receiving permission to conduct business in the state.

Yes, my definition of duty here sounds archaic and quaint, but the legal force of this concept remains in effect. So if the management team of a flailing penny stock corporation can only issue new shares at $1 while the stock trades at $0.30, what investor in his right mind would purchase shares from the management team at $1 when he can just go to the open market and buy the stock for $0.30?

There is only exception that is probably too obscure to mention, but I’ll go ahead and mention for the sake of being thorough: the only reason an investor would buy the $1 stock from the management team instead of the $0.30 option would be if he sought to purchase a much larger amount of the stock than was trading on the open market and the management team planned to issue as many new shares as the investor sought.

Outside of this rare occurrence, a stock trading below $1 effectively means that the management team cannot raise new capital by issuing new stock. This shuts the door on equity financing as a way to inject liquidity to stave off bankruptcy. The only remaining method for a corporation with shares trading under a dollar to raise money is through debt financing. Well, if a stock has lost over 90% of its value and cannot issue new shares, what kind of interest rates do you think these hypothetical lenders are going to demand? While staving off insolvency, the management teams of penny stocks will be forced to take on debt bearing 15-25% interest rates. It is the corporate version of those profligate shoppers shown on those Suze Orman horror stories in which someone earning minimum wage has to ship out nearly all of their earnings to credit card payments just to service the interest on their accumulated debt which signals no hope about the principal ever being repaid.

And lastly, there is a theory that a business has a greater value if it is more liquid. If the local farm has shares that trade as stock, it is worth more than a farm that acquires a buyer to show up and buy the whole thing outright because there is some economic value inherent in having the ability to buy and sell stock on a moment’s notice.

When a stock trades for less than a dollar for an extended period of time, it will eventually get delisted from the New York Stock Exchange. A stock doesn’t automatically get delisted the moment the stock falls below the $1 mark, but it sets into motion a probationary period that will eventually result in the business leaving the major stock exchanges to trade through the over-the-counter markets instead. This diminished marketability also takes a little bit of value off the stock. To be fair, this is one of the least of my concerns about penny stock investing.

I mention all of these things because, from a logical perspective, it shouldn’t seem to matter the price at which you’re granted access to shares. Heck, in Great Britain, there is even something equivalent to a low value stock market that has a proud tradition of producing blue-chip firms.

But that doesn’t work with penny stocks in the United States. Because stocks are initially listed at around $10 per share, the sub-dollar value means that the stock has already experienced at least a 90% price decline. The tradition of par value requirements when incorporating businesses also cuts out the possibility of equity-based financing for nearly insolvent firms, meaning that penny stocks are likely to carry debt at practically usurious interest rates. And lastly, the low trading value is often a precursor to delisting which means that the stock will have lower marketability and thus a lower value. I mean, can anyone even think of a penny stock investment that ever worked out well over a 5+ year time horizon? For the reasons mentioned above, I regard penny stocks as categorically poor investments.

Originally posted 2017-01-03 03:56:20.

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One thought on “Why Penny Stocks Are Bad Investments

  1. Thanks for the informative post. The way you narrated the post is good and understandable. After reading this post I learned some new things about penny stocks. Keep posting. Please let me know for the upcoming post.

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