A penny stock is a stock that is priced under $5. In general, most mutual funds will not invest in companies if their stock price is below $5.
The penny stock arena is analogous to swimming in shark infested waters. Buying penny stocks is also a bit like playing roulette. It’s probably about 38 to 1 odds you'll make money on a penny stock. And transversely, there's a 97% likely chance you’ll LOSE money on a penny stock. Only very experienced investors, using a small portion of their overall net worth, should speculate in penny stocks. I’ve classified penny stocks into six different types:
Fallen Stars are companies that had experienced tremendous growth at one time, and then lost the revenue stream. Such companies often reorganize, and if they stay solvent, re-focus their businesses. CMGI is an example, as they have reorganized from the old pre-2000 tech-bubble company. "Field Betting" is a strategy sometimes employed here by penny investors. That is, they buy a number of Fallen Stars in the hope that a couple do not go bankrupt, and actually experience tremendous growth again in the future.
Fallen Angels are companies that have been around for many years and then experience a large drop in demand for their products. Lucent is an example, as they had experienced huge growth in product sales in anticipation of "Y2K," and today Lucent was a much smaller company after a big drop-off in business. Field Betting is also sometimes employed here by penny investors.
Bankruptcy Plays is speculating on companies that are about to declare Chapter 11 bankruptcy, or are already in bankruptcy. Generally, the bondholders of a bankrupt company get all the equity ownership when it emerges from Chapter 11, and the current shareholders get nothing. At times, a warrant is issued to the old shareholders, which grants a right to buy the stock in the future at a higher price than it currently is [the company emerges from bankruptcy at $20, and a warrant is issued to buy the stock at $25 within the next 3 years...if the stock goes to $30, the old shareholders may gain something some day]. Penny investors sometimes employ a "sniping" strategy for companies that go bankrupt. That is, just before or after declaring bankruptcy, a stock may drop by 30%-50% for a few minutes and then bounce back. Putting a limit buy order at the low for that day is attempted.
Covert Fraud companies are entities that exist on toxic funding by constantly selling stock at a discount (see below). Such companies have little or no revenue. Management often pays themselves huge salaries.
Overt Fraud companies are entities that exist by toxically funding multiple companies. Company X may own Company Y and Company Z, all with zero revenue. Many optimistic press releases are published, and then mergers take place (in reality, shell companies are buying shell companies). Micro-Cap companies are undercapitalized small organizations. A technology or other company may have received seed money and then had cash flow problems. Venture capitalists often fund a certain amount, and then will not fund further. A delay in future revenue may cause a small company stock to drop from $10 to $1. Micro-Caps are the most viable investments in the penny stock arena, but are extremely risky just the same.
TOXIC FUNDING, also known as DEATH SPIRAL FUNDING, is legal fraud in this author’s opinion. Toxic funding is when companies sell stock at a discount to raise cash. A stock may be selling for 50 cents, and the company sells 10 million shares at 35 cents in a private placement to a special investor. The net result most often is the stock dropping from 50 cents to 35 cents on the announcement. Quite often these small companies pay their management huge salaries, so they are essentially borrowing money to pay themselves, all the while diluting the ownership of the current shareholders. Most companies that toxically fund go bankrupt.
What to avoid with penny stocks: Hearsay advice or tips from friends. Spam emails pushing penny stocks. Many press releases from a company with little or no revenue. Not filing SEC reports on time. Buried negative information in the SEC reports. Management burning cash by buying officers and directors insurance for big bucks. Reverse splitting the stock. Incorporated in Florida or Nevada. Signing employment contracts with management. Loans from management to the company which is really funded by selling self-issued stock, etc.
Penny researchers should use a stock screener for micro-cap companies and sort by lowest price. Read the SEC reports and calculate the cash burn rate for a potential investment. If a company used $5 million in cash in three months, and now has only $10 million, in three to six months they’ll likely need to toxically fund and the stock will drop even further. Fallen Angels are often worth researching as they usually have much lower burn rates. Field Betting reduces risk, but again, penny stock investing is essentially a high-risk gamble for that one stock that goes up a lot.