Penny Stocks – Elements 32

This post is part of the Elements series, a Periodic Table of all the Investing Elements that you need to take control of your financial life. You can find the rest of the posts here.

Penny Stocks

What is it?

The term “penny stocks” originated in the US, where most shares are valued in multiple dollars (usually more than $10 per share).

• Any stock priced at less than $1 per share was a penny stock.
• There is inflation in all things, however, and US stocks priced under $2 or even under $5 per share (the SEC definition) are known as penny stocks these days.
• When it came over to the UK, it was translated as stocks trading for less than £1 per share.

Now £1 <> $1, and most share prices in the UK are below £10, whereas in the US many stocks trade above $10.

• So here in the UK, a stock trading in the pennies is not so unusual, nor so extreme, as it would be in the States.

But on both sides of the Atlantic, it began as a term for stocks trading at a low value (which had presumably fallen from a higher value).

What kind of element is it?

Penny Stocks are a subdivision of the Equity asset class, but for our purposes today, they are an Inessential Element.

• That’s because it’s not essential for anyone to buy Penny Stocks.

Who needs it?

As with all the elements in the inessentials row, this is the crux of the matter.

• So obviously, the premise is that nobody needs it.
• Mostly because penny stocks are high risk (see below).

Safer, more useful and more important places for your money include:

1. repaying expensive debts, especially short-term debts
2. building up an emergency fund (perhaps in a cash ISA)
3. contributing to your workplace pension, which should attract matching contributions from your employer
4. paying off some of your mortgage (if you are a homeowner)
5. making contributions to a SIPP (particularly if you are a higher-rate taxpayer)
6. using up your annual contribution limit to an ISA (stocks and shares, not cash)

Since the 2017/18 limits for pensions and ISAs are £40K and £20K respectively, this should take care of between £80K and £100K of salary for most people.

• This would be a remarkable savings rate of between 60% to 80%.
• Depending on how quickly you want to retire, you would usually be ok with saving between 15% and 20% of your income.

But the basic point is that penny stocks should only be of interest to those with large portfolios, who can devote a small proportion of their net worth as “play money”.

High risk investments of all types should only be considered by people with moderate to large portfolios.

• Let’s say people who have bought a home to live in (via a mortgage), and also have £250K of savings.

The government restricts the marketing of certain investments to “sophisticated” and “high net worth” individuals.

• These are people earning more than £100K pa, and / or with £250K in liquid savings beyond their home and pension.

But penny stocks aren’t on the list of restricted investments.

What comes before it?

Repaying debts, an emergency fund, your workplace pension, paying down your mortgage, SIPP contributions, ISA contributions.

What comes after it?

Only the most esoteric stuff, some of which is also  Inessential:

• Hedge Funds, Gold, Commodities, FX trading, Spread Bets, SWAG, Options and Warrants.

What age do you need it from?

• It’s an Inessential, so strictly, never.
• As a high-risk subdivision of equities, you’re unlikely to have a big enough net worth for Penny Stocks to be appropriate until your late thirties.

What age do you need it until?

Individual penny stocks are definitely not the sort of thing that you’ll want to hang on to over the long term.

• But if you decide to have a play money section to your portfolio, then penny stocks would be filed under growth assets, like all the other equities.

And so, like equities, you might keep them until you decide to switch from your own retirement portfolio into a monthly annuity payment.

• Given current interest rates and longevity projections, this is unlikely to be before the age of 75.
• Or alternatively, when you have failing mental faculties.

How much does it cost?

Penny stocks don’t appear at first sight to be expensive.

• Most are listed on AIM, where there is no stamp duty
• So you could make a purchase or a sale for £5.

But penny stocks are illiquid, and the bid offer spread could be 10% or more, compared with less than 1% for a blue-chip stock.

What’s in it?

Penny stocks are high volatility, high risk, listed equities.

• They can quickly crash in price, but they can also go up quickly, which is why they attract a certain type of investor.

Penny stocks fall into three main categories:

1. “Blue-sky” story stocks (often in the tech sector) that haven’t made much in the way of profits yet, and have probably been losing money for years, but still promise jam tomorrow.
2. “Binary” stocks in highly speculative industries, like oil and gas explorers, and precious metal miners
3. “Fallen angels”, who used to be profitable, but operate in a structurally declining sector, or have suffered some catastrophe specific to them.
   • These stocks could be highly leveraged, and close to bankruptcy.

Not a particularly promising bunch, are they?

• Lots of studies show that lower-priced stocks do worse than higher-priced stocks.
• That’s in line with the general finding that less volatile stocks outperform more volatile stocks.
• But contrary to the the general outperformance of smaller stocks over larger stocks.

The trick is not to go too small.

Everybody’s definition of what constitutes a penny stock will be different, but mine is:

• Share price below 50p.
• Market cap below £50M (though I have been known on occasion to lower this to £40M).
• If you are particularly cautious, you might want to stick with firms above £1 and £100M.

In the US, penny stocks trade on “over the counter” markets like the Pink Sheets or FINRA’s OTC Bulletin Board (OTCBB).

• Here in the UK, most of the penny stocks are on AIM (the Alternative Investment Market).

Regular readers will know that I am a big fan of AIM.

• It’s been around for more than 20 years now, and there are some great stocks on there.
• They are cheap to trade (no stamp duty), they are allowed in your ISA and after 2 years you have protection from IHT.

But AIM has much less onerous entry and regulatory requirements than the main market.

• To list on the main market, a company needs to have audited financial records for three years and to be worth at least £700,000 – and 25% of shares must be held in public hands

There are few / weak rules on things such as minimum trading history, market capitalisation or proportion of shares which have to be publicly traded on AIM.

• Shareholder approval is only needed for the largest transactions, and financial disclosure and reporting requirements are generally less demanding.

AIM relies on a system of nominated advisers, or nomads, whose job is to ensure the probity of their companies.

• When a nomad quits, the firm has a month to find another one, or it is delisted.
• Inevitably, nomads vary in quality and trustworthiness.

Most of the listings themselves are of poor quality.

• Few make it up the main list, and many don’t even survive on AIM for long.
• It’s not known ad the “casino” for nothing.

AIM also has investors who are typically younger than the average private investor in the UK.

• A recent TD Direct Investing survey found that the AIM index (the biggest and theoretically the safest stocks on AIM) had three-and-a-half times more 30- to 44-year-old investors than those over 45.

Out of around a thousand stocks, maybe 200 are good. (( Everyone will have their own estimate, but I haven’t met an experienced AIM investor who puts the proportion at more than 25% ))

• Of particular concern are foreign stocks – listings from China, Israel and Greece have run into trouble in recent years.

Research in 2016 by Dimson and Marsh at the LBS found that 72% of all the stocks to have ever listed on AIM would have lost investors money.

• In more than 30 per cent of cases, shareholders lost at least 95% of their investment.
• They also found that AIM has delivered a negative total return of 1.6% a year since its inception .

Aim’s 20 years are usually blamed on a high weighting of resources stocks (around one-third of listings) and lots of IPOs.

• There’s also a tendency towards following investment fads – the low cost of listing attracts many opportunist compaises to the same trend, and most will fail.

There have been some big winners, though.

• £1,000 invested in ASOS when it listed on Aim in 2001, would have been worth £162,130 by the time of the study, equivalent to an annualised return of 45%.
• There are 39 companies (1.4% of all listings) that have delivered returns in excess of 1,000% (ten baggers).

And a welcome trend is the increased competition for early stage funding – as well as AIM and VCTs, we now have crowdfunding and the British Business Bank.

• This should mean that firms come to AIM later, and in better condition.

What does a good one look like?

Let’s turn this question around, and look at why people – and which people – like penny stocks.

There are three reasons they are popular in some quarters, and they all appeal to the same type of investor:

1. They are volatile and so in theory you can make money quickly.
   • you can of course lose it just as quickly, and most people do this instead
2. You get a lot of shares for your money, so your £1000 goes a long way.
   • you aren’t really getting more for your money, but to some people it feels that way
3. Inexperienced investors think they must be cheap and that they have a lot more room to rise than fall.
   • but it’s just as hard (harder, actually) for a 50p stock to hit £1 as it is for a £5 stock to reach £10
   • and every stock has the same distance to fall – 100%, back to zero

Who does this attract?

• The “get rich quick” types with small portfolios.
• The ones who check share prices every 30 mins and tweet when one of their stocks has a good day.
• The young investors.

Things have got worse in the age of the internet.

• First we had the bulletin boards, but now we have Twitter as well.
• Everybody has a friend of a friend, or a Twitter friend, that made a mint in penny stocks.

And maybe a few of them did, but most of them are paid promoters of stocks.

• They “ramp” (up) and “de-ramp” down the share price to make money out of mug-punters.

What does a bad one look like?

They are pretty much all bad – that’s why they are worth pennies.

• As discussed above, they usually have no profits, large debts, low public floats and binary future prospects.

Any recommended brands?

There are no brands of penny stocks.

• In fact, this is an area where “branding” would almost be synonymous with “recidivist”.
• If you see a familiar face (broker, nomad or company officer) who has been involved with other penny stocks, you should run quickly in the opposite direction.

What are the main risks?

We’ve covered quite a few of the risks already, but here are a couple more.

As well as being risky (in the permanent loss sense) and volatile (in the price fluctuations sense), penny stocks are also illiquid.

• The value of shares traded on average each day will be low.

This means in a best-case scenario that they are expensive to trade because the bid-offer spread will be wide as a percentage of the mid-price.

• Most blue chips will have a spread of less than 1%, but for penny stocks this number could be 5% or even 10%.
• That means that as soon as you buy, you need a 10% increase just to break even.

In a worst-case scenario, it means that you won’t be able to sell them in decent size on bad news at anything like the official price.

And in the average case scenario, it means that if you try to build a big position in a penny stock that you are sure is “primed for a move”, then the price will run away from you.

• As you pile in, you will drive the move yourself, only to be left at the end holding the stock at a price where there are no other buyers.

Lack of liquidity, often coupled with small public floats, also means that it’s easy for rampers / de-rampers to move the stock price by buying (or selling) a few shares.

The typical procedure is known as a “pump and dump”.

• Here insiders talk the stock up in public (on bulletin boards and Twitter) whilst selling their holding in private.
• They will tell you its a “no-brainer” and will “multibag from here”.
• They might add a few rocket emojis.

This is supposed to be illegal (“market abuse”) but very few people seem to be prosecuted for it.

Insiders will stress the multibillion-dollar market that the company will operate in, and the enormous profits to be generated when their proprietary technology hits the market.

• Sometimes they will hint at a deal with (or even a takeover by) a market giant or hero (Apple, Google, Microsoft and Tesla are common at the moment).
• They’ll tell you about the mine / well next door, or the brilliant results of the Phase 1 trials.
• But they won’t talk about the current profits, because there won’t be any.
• And they won’t mention the insiders selling off their stock.

There’s also the opposite sort of scheme, where scammers short a stock and spread rumours to drive it’s price down.

• This is not as common or as dangerous to regular investors, since when the operation is over the stock should return to it’s natural price.
• Your loss is probably temporary.

The final problem comes from the small market cap of the stocks.

• Small stocks have no reserves with which to absorb negative events.
• One bad quarter or unexpected liability and they can be out of business.

How do you deal with these risks?

The best advice is simply to not buy penny stocks at all.

If you must indulge, then:

1. limit your holdings (to say 5% of your overall net worth)
2. diversify within your penny stocks – don’t have more than 5% of the 5% in a single stock
3. check liquidity (spreads and trading volumes) before investing
4. book your profits – this goes against the usual advice of Let Your Winners Run, but different rules apply to penny stocks