Penny stocks are an interesting investment choice. They’re cheap, so you can buy many shares for a small sum. Plus, thanks to the low stock price, tiny movements can create big gains. The problem is, penny stocks are very risky.
Read on to learn the good, bad and ugly aspects of penny stocks. You’ll also meet five alternative investments that have a better risk/reward profile.
What Is A Penny Stock?
A penny stock is a common share that trades publicly for less than $5. These securities usually represent ownership in smaller, less established companies. Most of them trade over the counter, rather than on an exchange like the New York Stock Exchange (NYSE) or the Nasdaq Stock Market (Nasdaq).
Penny Stocks: What’s Good
When penny stocks mature into respected, in-demand securities, they generate massive gains for shareholders. Take Advanced Micro Devices (AMD) as an example. This stock traded for less than $2 per share in 2015. Today, you’ll spend around $100 to buy one share. That amounts to compound annual growth (CAGR) of about 65%.
Said another way, a cash-strapped investor could have put $100 into AMD in 2015. In 2023, that position would be worth $5,200.
Therein lies the appeal of penny stocks. Like spending $2 on a Powerball ticket, the buy-in is low and the upside is high. Also like the lottery, many people play penny stocks and relatively few win.
Penny Stocks: What’s Bad
Three factors create excess risk for penny stock investors. Demand for these securities is low, many of them operate with minimal regulatory oversight and they often have lower financial qualifications than conventional stocks.
1. Low Investor Demand
Penny stocks have a low price tag because investor demand is low. That can make it tough to sell penny stocks—at any price, let alone a profitable one.
2. Lesser Reporting And Disclosure Requirements
Stocks that trade on the Nasdaq and NYSE are subject to SEC reporting requirements. They must file quarterly and audited annual financial statements. They must also report on significant events like acquisitions, amendments to the charter and changes on the board.
These filing requirements provide investors with some transparency into business operations and performance. Over-the-counter (OTC) penny stocks don’t offer that same level of transparency.
There are three main markets that list OTC stocks: OTCQX, OTCQB and Pink. OTCQX enforces some reporting and oversight, more so than OTCQB. Pink-listed stocks have no SEC registration or disclosure requirements.
Without the standardized, audited reporting the SEC requires, it’s challenging to judge a business’s potential. Worse, the lack of oversight allows some companies to release misleading or inaccurate information, solely to drum up investor support.
3. Lesser Financial Qualifications
For a stock to trade on the NYSE or the Nasdaq, it must meet the exchange’s requirements for earnings, capitalization and corporate governance. Those requirements help safeguard investors from fly-by-night businesses. OTC penny stocks have lesser or no requirements in those areas, depending on where they trade.
For the record, AMD was not a typical penny stock. While the company initially went public by selling shares directly to investors in 1972, AMD was trading on the Nasdaq when it fell into hard times in 2015.
While penny stocks may be cheap, they are very risky. The Forbes investment team recently released 7 Best Stocks to Buy Now (That Are Better Than Penny Stocks). These stocks are less risky and have the potential for higher gains. Click here to download it now.
Penny Stocks: What’s Ugly
Because penny stocks operate with less regulatory oversight than exchange-traded stocks, the industry is prone to fraud. Penny stock investor scams are rampant and can involve:
- Shareholders spreading misinformation to boost a stock’s price. When the price goes up, the fraudsters sell their shares. The stock crashes and remaining shareholders are left with worthless positions.
- Companies issuing stock repeatedly with no business plan other than to pocket investor dollars.
- Brokers buying stocks for pennies and then reselling them to unsuspecting investors at much higher prices.
Scams targeting penny stock investors can generate illicit profits in the tens of millions of dollars.
What Alternatives Are There To Penny Stocks?
To invest on a budget, there are better options than penny stocks. Three to consider are exchange-traded funds, fractional shares and small-caps.
ETF Investing
ETFs are pooled investment funds. When you buy one ETF share, you get exposure to every stock the ETF owns. This is an efficient way to secure a diversified portfolio.
You can also choose your risk level with ETFs. If you’re conservative by nature, you might put money into an S&P 500 fund like SPDR S&P 500 ETF (SPY
PY
SPY
). You’ll spend about $420 on one share, but you’ll have exposure to 500 of the largest and most successful stocks in the U.S.
You could also use ETFs to generate income by investing in the best dividend stocks. See my list of the best dividend ETFs for 2023.
Or, if you have more appetite for risk, you might prefer to use ETFs to invest in the best AI stocks for 2023, biotech stocks or renewable energy stocks.
Whatever your investment approach is, you can likely find an ETF to fulfill it.
Fractional Shares
Fractional investing is the practice of buying stocks in units of less than one. As an example, if you want to own Amazon
AMZN
but can’t afford the $125 price tag, you could buy one-tenth of a share for less than $13.
Fidelity and Schwab support fractional investing, as does Robinhood and other investing apps. Be sure to choose a fractional investing broker that offers no-fee trading. Fees on small stock trades can easily consume your returns.
Small-Caps
If the high-risk, high-reward aspect of penny stocks appeals to you, small-caps may be your best alternative.
Small-caps are not as established as S&P 500 constituents, but they are SEC-registered and exchange-traded. As such, they’re far more likely to represent legitimate businesses than penny stocks.
Small-caps are valued between $250 million and $2 billion. They can produce jaw-dropping revenue growth, earnings growth and shareholder gains as they evolve into mature companies. The downside is that small-caps can be volatile and highly sensitive to macroeconomic trends.
5 Best Penny Stock Alternatives
Below are five small-cap stocks with attractive valuations and less risk than penny stocks, courtesy of Forbes Investor Editor Taesik Yoon.
Yoon has identified these as “pullback stocks” for 2023—that is, stocks that are temporarily down after reaching new price highs. Pullback stocks can be great bargains with strong upside potential.
All stock metrics below are from Morningstar.
1. Willdan Group
WLDN
- Market cap: $277 million
- Stock price: $20.43
- Price/sales ratio: 0.58
- Trailing 12-month revenue: $456 million
- Trailing 12-month diluted EPS: $0.08
Willdan Group provides services and consulting to utility and energy companies, helping them optimize and run more efficiently.
In 2023, WLDN has improved its margins and produced double-digit revenue growth. Analysts largely expect the growth to continue through the end of 2024. Key factors are the company’s attractive book of outsourcing contracts with investor-owned utility companies in California plus a software offering that should benefit from increasing demand for alternative energy solutions.
2. EZCorp (EZPW)
- Market cap: $454 million
- Stock price: $8.25
- Price/sales ratio: 0.64
- Trailing 12-month revenue: $1 billion
- Trailing 12-month diluted EPS: $0.49
EZCorp funds loans collateralized by personal property. It also sells used merchandise through its network of pawn shops in the U.S. and Mexico.
In 2023, EZPW has beaten consensus estimates in the first three quarters by a cumulative $0.19. The outperformance is related to the company’s long-term strategy to improve profitability by expanding into Latin America. As of the end of the third quarter of 2023, EZPW had a record $229 million in loans outstanding.
Inflation-driven demand for loans and low-priced goods should continue to benefit EZCorp going forward.
While penny stocks may be cheap, they are very risky. The Forbes investment team recently released 7 Best Stocks to Buy Now (That Are Better Than Penny Stocks). These stocks are less risky and have the potential for higher gains. Click here to download it now.
3. Varex Imaging (VREX)
- Market cap: $759 million
- Stock price: $18.79
- Price/sales ratio: 0.86
- Trailing 12-month revenue: $897 million
- Trailing 12-month diluted EPS: $0.72
Varex makes components for medical, industrial and scientific X-ray applications.
Investors have punished VREX recently for forecasting lower-than-expected performance for the current quarter. The softer outlook, however, is likely related to temporarily high-cost inventories that are impacting margins—an issue that should resolve in six months. This looks to be a good buying opportunity for a stock that has a history of beating profit expectations.
Going forward, VREX will benefit from solid demand for its industrial products, detector platform and detectors.
4. Great Lakes Dredge & Dock (GLDD)
- Market cap: $529 million
- Stock price: $7.97
- Price/sales ratio: 0.87
- Trailing 12-month revenue: $595 million
- Trailing 12-month diluted loss per share: $0.65
Great Lakes Dredge & Dock is the largest dredging contractor in the U.S.
Twice this year, GLDD has beaten analysts’ earnings expectations. In the second quarter, for example, GLDD produced EPS of $0.03 when analysts had predicted a $0.10 loss per share. The outperformance can be attributed to cost reductions, improved project performance and fewer dry dockings.
Improved efficiency, a pickup in contract awards and a $900 million backlog position GLDD well for gains going forward.
5. Blue Bird (BLBD)
- Market cap: $686 million
- Stock price: $21.35
- Price/sales ratio: 0.62
- Trailing 12-month revenue: $1 billion
- Trailing 12-month diluted loss per share: $0.58
Blue Bird is a leader in the design and build of school buses in North America.
The company is on the backside of an extended operational decline prompted by the Covid-19 pandemic. BLBD had to manage through poor demand for school buses and severe supply chain constraints.
The good news is that BLBD survived those tough conditions, reduced its manufacturing costs and returned to profitability. In the last two quarters, the company earned $0.71 per share vs. analysts’ expectation of $0.33 per share. BLBD is now on course to produce $73 million in adjusted Ebitda this year and $100 million in annual adjusted Ebitda within the next couple years.
Bottom Line
Penny stocks are risky—risky enough to be characterized as gambling. Your safer options include ETFs, fractional shares and small-caps. A well-researched portfolio of small-caps at attractive valuations can deliver a nice rush of risk and reward. You’ll get all the excitement of stock ownership, without having to manage the seedy underside of penny stocks.
While penny stocks may be cheap, they are very risky. The Forbes investment team recently released 7 Best Stocks to Buy Now (That Are Better Than Penny Stocks). These stocks are less risky and have the potential for higher gains. Click here to download it now.
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