In the world of DIY investing, penny stocks are often viewed as the ultimate opportunity to bag a 10x-er – that one stock that increases in value by 10 times (1,000%).
While the theme of exponential gains from a relatively small capital outlay is what draws investors in, the reality of navigating penny stocks requires a sharp eye for value and a stomach for volatility.
In For a Penny
A penny stock is a Wall Street term for a share that trades for under $1 or even a fraction of a cent – the Securities and Exchange Commission (SEC) defines a penny stock as a share that trades for less than $5.
These companies are typically micro-cap or nano-cap companies – listed companies with market capitalisations below $300 million. In the US, true penny stocks are abundant, especially on the Over-the-Counter (OTC) bulletin boards.
Examples of US-listed penny stocks include:
- JetBlue Airways (JBLU): Airline
- Vaxart (VXRT): Biotech
- ThredUp (TDUP): Online resale marketplace
- Real Messenger (RealX): Real estate messenger app
- Banco Bradesco (BBD): Brazilian bank
- Grab Holdings (GRAB): A Southeast Asian tech firm
Cent stocks
While less common among do-it-yourself (DIY) retail investors in South Africa, the JSE’s micro-cap section – typically, companies that have a market capitalisation below R525 million – also holds stocks where a small investment could, theoretically, turn into a substantial sum.
These stocks, which are more often found on the AltX (Alternative Exchange), and operate below the radar of big institutional investors, are also defined by their low absolute share price, which mainly includes companies trading for less than R5 per share.
For an investor with a few thousand rand to invest, these stocks allow you to buy hundreds or even thousands of shares, creating holding power should the stock price rise substantially.
Examples of SA micro-cap stocks include:
- 4Sight Holdings Ltd (4SI): Technology
- RH Bophelo Ltd (RHB): Finance
- Nictus Ltd (NCS): Distribution services
- Trellidor Holdings Ltd (TRL): Producer/manufacturing
- Brikor Limited (BIK): Non-energy minerals
- South Ocean Holdings Ltd (SOH): Producer manufacturing
Risk and Reward
While all DIY traders and investors aim to achieve outsized gains, it is essential to determine whether penny stocks have a place in your portfolio.
As with any investment, the potential for high growth typically comes with higher risks, and that is true of penny stocks.
The penny stock risks include:
- Higher volatility: Penny shares are often more volatile than other stocks because they belong to companies that are either very small or newly listed.
- Unproven track record: Penny stock companies don’t always have a proven record of success as a publicly traded company.
- Low liquidity: Many penny stocks have very low trading volume. This means you might be able to buy shares, but when you want to sell, you may not find a buyer, or you might have to a price that is significantly lower than you expected.
- Information asymmetry: Reliable information about these companies is often scarce, making it challenging to perform the necessary due diligence. They may not have the same rigorous disclosure requirements as larger companies, making them prone to manipulation and “pump-and-dump” schemes.
- Susceptible to market cycles: Penny stock companies tend to be small, which means they are sensitive to market news and developments, and prone to bankruptcy.
However, many of the potential risks also hold the potential for greater rewards. For example, there’s a possibility that stocks could be undervalued (as they belong to smaller companies), which means more room for share price growth.
The low price per share also means DIY investors can get exposure to a large amount of shares at a relatively low cost. And since penny stocks trade at a lower price point, an incremental movement in their value could translate into a high percentage share price change quite easily.
The higher volatility inherent in penny stocks also creates both traditional trading (buying) and short-selling opportunities.
Penny Wise Investing
For someone who is actively trading (buying and selling stocks over days, hours, or even minutes), penny stocks offer a high-octane environment.
Penny stocks can move up or down 20%, 50%, or more in a single trading session. This volatility creates potential for quick profits, but it also means massive and rapid losses are possible.
If you trade penny stocks, use tight stop-loss orders, and have a clear entry and exit strategy. Position sizing is also crucial – never invest money you cannot afford to lose, ensuring penny stocks remain a tiny fraction of your total self-directed portfolio.
For the DIY retail investor who wants to build a portfolio over the long term, any investment in a penny stock should be viewed as that one-in-a-hundred company that will grow into a major success story – those elusive 10x-ers or 10-baggers.
Due to their extreme volatility, low liquidity, and high business failure rate, these stocks should occupy only the smallest, most speculative corner of your portfolio.
