TickTock is riddled with horrible financial advice, no surprise there. But I saw one yesterday that made me think about a widespread misconception about penny stocks. In this TickTock, this person told people never to buy stocks below a specific price, i.e., penny stocks. TickTock is full of young folks who haven’t spent enough time in the markets, but many people agree with this person regarding lower-priced stocks. Is there such a thing as safe penny stocks? Does price have anything to do with risk? Am I safer only buying stocks over $1 or $4 or $5?
Penny Stock Definition
The definition varies here, but the concept is the same. Penny stocks are stocks of typically smaller companies that trade at less than $5 by some definition or $1 by others.
The logic goes that low-priced stocks are more volatile, and that is generally true. Penny stocks attract all kinds of “gambling.” From day-traders to pump-and-dump schemes. They hope that due to low trading volume, by simply buying the stock, they can influence the price, especially if they can pump the price through social media channels or their followers.
There is some truth to that, but not all penny stocks are made the same. Unlike traders, who buy and sell stock tickers, we invest in underlying companies. Therefore, price only becomes part of the equation. We said it many times, the value you get is always a function of the price you pay. Therefore the only difference the low price makes is the market capitalization of the company.
The best way to illustrate this is through the simple fact that penny stock companies grow up to be great businesses and that large stocks can fail miserably, no matter the price the stock is trading at.
Big companies that were once penny stocks
If you follow a definition that penny stock is a stock below $5, many big successful companies today were once penny stocks. The difference between these companies now and then is their size and market capitalization.
Apple today doesn’t need an introduction. It is the biggest tech company globally, but it was a penny stock not too long ago. In 2009 you could have bought Apple stock for under $5.
Was it a good investment at below $5? It is impossible to say. At $5 back then, it might have been too expensive. Was Apple a safe penny stock? Far from it, but not investing in it just because of the price is not sound investing.
Here is how Apple has performed since that time, compared to the S&P 500 ETF, SPY.
Okay, this chart is absurd, we know, but it is still fun to look back at how crazy Apple’s performance has been since it was a penny stock.
Here is the summary:
Was Apple one of the safe penny stocks? Definitely not. Just look at that volatility. But with higher risk came the reward.
Ford Motor Company (F)
Another company that needs no introduction that you could have also bought at below $3 in 2009 is Ford. A company with hundreds of billions in revenue, with the best-selling vehicle in the United States, and one of the most well-known car makers in the world was also a penny stock.
Here is how Ford has performed since that time, compared to the S&P 500 ETF, SPY.
Not as impressive performance as Apple. Here is the summary:
Advanced Micro Devices (AMD)
Just six years ago, you could have bought AMD below $2. Stock that is now trading at over $80.
Here is how AMD has performed since that time, compared to the S&P 500 ETF, SPY.
So hopefully, from this, you can see that if you were to implement this hard rule of never considering companies under a [insert $ price] here, you would miss out on some potentially incredible returns.
Again, this is not to say that these companies were good investments at the mentioned prices.Many of the above listed companes did not perform better than S&P500 over the long period.
We must remember that price does not equal value. Cheap doesn’t mean good and certainly doesn’t mean we should expect outsized returns. Many penny stocks investments fail. But they fail not because the stock is a penny stock but because the company underneath is poor-quality, likely in debt, or just plain scammy, crappy business.
Big companies that failed but were not penny stocks
The list, as you can imagine, is endless. Still, it is good practice to look at these from time to time to remember that stock price is not the point but rather company operations and, most importantly, debt overhang that kills these once flourishing businesses.
Few notable retailers that have filed for Chapter 11: J.C Penney (JCP), Sears Holdings (SHLD), Macy’s (M). Energy names like Chesapeake Energy, Seadrill (SDRL), These investments would give us a hefty loss if held until the very end.
Here are just a few of the stock charts of these failing companies.
Lessons from these penny stock successes and non-penny stock failures
Buying an investment in a massive retail giant like Macy’s or J.C Penney was supposed to be safer than buying a penny stock. Yet, these companies produced massive losses.
Why does it happen?
Fundamentals always prevail. No matter how much traders, commentators, wall street, or whoever tries to advocate for a company, business operations, and fundamentals win at the end of the day. The math is simple but can be hard to do. If a company cannot generate enough free cash to pay for its high debt, bankruptcy is imminent. Fundamentals always prevail.
Within their specific sectors, these companies face many obstacles. Some of these obstacles are global, like the COVID pandemic. Some are significantly region or industry-specific. It doesn’t matter; does the company have low enough leverage not to get into trouble when these obstacles arise?
To quote Warren Buffet:
“When you combine ignorance and leverage, you get some pretty interesting results. The leverage could help a stock outperform and make your spouse think that you are clever, while your neghbors get envious. But history tells us that leverage all to often produces zeroes.”
Is there such thing as safe penny stocks? Potentially, if the underlying company is not leveraged with solid fundamentals and is overlooked by the general market.
It does not take away from the fact that speculators and pump-and-dump schemers love to manipulate penny stocks. As a result, penny stocks do have higher volatility and lower liquidity. You have to keep that in mind. But at the same time, don’t judge the company solely on its stock price.
Instead, scrutinize the underlying business. Focus on leverage and how sustainable it is. Otherwise, you can miss incredible microcap companies that one day might not be microcap anymore. These are the type of investments that produce returns that the industry calls multi-baggers, which double, triple, or quadruple your original investment. These are rare as they require either a lot of skill or luck or both, but they will never happen if you ignore stocks that fall into the penny stock category. Price as always does not equal value.
If you are not sure where to begin your investing journey, take a look at our short investment guide.