Buying penny stocks is not for the faint of heart. The occasional extraordinary gain is overshadowed by the enormous risk not only inherent to the stock itself but also due to other factors.
“Some of our past penny stocks alerts have seen gains of up to 500% or higher in only ONE day! Signup for our list of penny stocks.”
-From an advertisement on StockFreak.com
A Story too Outrageous to Believe (except that it is true)
There is a way to make money in penny stocks, but it isn’t from buying them outright such as the ad above suggests. Instead, loan money to a penny stock company in need and make an iron clad agreement that your equity can be paid back with corporate stock at half its market price if the small company loses value.
This scenario happens because penny stock businesses are often woefully undercapitalized and need cash infusions. Banks aren’t ready to help the small company because of the risk. So, they turn elsewhere. Enter a clever private investor. Let’s say it is you.
If you loaned $100,000 to a penny stock company trading at 4 cents a share, you wait until they pay it back or need more money. If the stock goes up, the corporation can pay you back. Sadly, this does not always happen in failing businesses that have to seek emergency private funding.
Then, the stock goes down, say to 3 cents per share. Now, the company owes you your loan equity in stock valued at one and a half cents a share, rather than three (half its current price). You sell the stock on the open market and double your money. This makes you happy. Well, it could have, but you really didn’t do this. However, someone else did.
Enter, Josh Sason. He is said to have made millions (see Bloomberg Businessweek March 16-27, 2015, pages 50-55) in the little-known and unique type of business venture just described. The money the 27-year-old makes for his trouble supports his opulent life style. This includes a lingerie model girlfriend and jet setting all over the globe, for example Malaysia. Need I say more?
The Death Spiral
Sason is also entering other projects in an effort to diversify what some call a “death spiral.” By this, they are not referring to young Sason, but rather the small companies to whom he loans money.
This is why. Consider what happens to a struggling business that takes a loan from the not-even-30-year-old entrepreneur several times. Its price per share is diminished as Sason sells his undervalued stock at market price. When this happens sequentially, the stock price can be driven to zero. Shareholders that invested in the company in a traditional way (by buying the penny stock at market price) suffer. Unbelievably, Sason’s maneuvers are apparently legal. That may be why he is entering other businesses. The young man sees the handwriting on the wall in terms of eventual government intervention.
The Real Skinny (What you need to know)
Penny stocks used to be thought of as those that traded at less than one dollar per share. Recently, this definition was officially revised by the Securities and Exchange Commission to include all stocks trading below 5 dollars. These are small companies with limited cash and typically low trading volume. For these reasons and others, they are more susceptible to market manipulation than stocks found on major exchanges such as the NASDAQ and the NYSE.
All of this means that buying penny stocks is not for the faint of heart. This is because the occasional extraordinary gain is overshadowed by the enormous risk not only inherent to the stock itself but also due to other factors. For example, there is the common “pump and dump” scheme consisting of fraudulent promotion of a stock so that others buy it. Then, the endorsers sell while the price is high. This situation was portrayed in the movie, “The Wolf of Wall Street.” There are even some penny stock companies that consist of only a CEO receiving salary from shareholders, without any legitimate business to produce returns for these investors. Now, we have a new twist—a clever young man who makes money while shareholders’ returns are diminished. The list of reasons not to buy penny stocks is growing ever longer.