How do penny shares work?
My article this week looks at penny shares, which have been cropping up since time immemorial as a brilliant ground floor stock market opportunity.
In fact, I’m looking at an advertisement for a tip sheet now which talks about penny shares they have punted over the last year, some of which have doubled, even tripled in value… they mention 10 shares which have risen by an average of more than 200%, against the top ten shares on the FTSE rising by an average of just 67%.
It’s certainly appealing to those of us wanting to make money from shares. And it’s all undoubtedly true… but CERTAINLY not the whole story.
First… what are penny shares. These are stocks that have an ultra low price, often just a few pence apiece, as opposed to the typical share, with values in the tens or hundreds of pence.
The appeal is obvious. They offer a cheap way in to the market, and they apparently have lots more potential to rise - after all a 5p share has to have more growth potential than a 500p share, right?
This totally relies on people’s perception that they have ‘missed the boat’ with big blue chip shares. That it’s now too expensive to get into BT, Cadbury, HBOS, M&S and the like. Why buy at the top of a market when you can get in at the bottom.
And it’s true that all blue chips started as penny shares, some not so long ago. Microsoft and Cisco Systems were penny shares within fairly recent memory… so why can’t you get in on the next big surge.
A big problem here is lack of information. These shares are generally of companies that aren’t listed on the major exchanges, such as the FTSE 100.
They don’t have to disclose the same data on directors, performance and the like as the Blue Chips. So not only will researching them be hard, but misinformation can be rife.
In short, many of the tipoffs so beloved of small investors - that Inahole Mining is just about to strike the motherlode, or that Hadja Chips has just developed a miracle new microprocessor that Intel wants to buy - are nonsense. Lies, made up by pump and dump merchants.
Pump and dump works like this.
A person buys a stack of the worthless company stock, and starts spreading a rumour to PUMP the price.
The rumour attracts naive punters, on whom the pumper then DUMPS his stock at the inflated price… And swiftly exits. Unethical and sometimes illegal, but very hard to prove. Boiler Room share operations specialise in pump and dump.
Another big problem is lack of liquidity. These shares are cheap, in large part, because nobody is buying them. And if nobody is buying, then you’re going to have a big problem selling them if you need to. Prices are just nominal until somebody actually buys - if nobody will trade with you then your stock is worthless.
It’s also a nonsense just to value on price. I know the ersatz Mars Bars from LIDL are much cheaper than the real thing… I also know to my cost that there’s a reason for that. Price means nothing without measures such as earnings per share, assets per share and the like. VALUE in other words.
And talking about earnings per share - these guys aren’t going to be paying you a dividend, unlike blue chips. Remember, it’s not JUST about share price, it’s earnings too.
Ask yourself WHY this stock is a penny share. It may be on the way up, but it may be on the way down and out.
Also recognise that a low share price is invariably a reflection of a small cap (a company with small amounts of capital). Many of these small cap companies are newly formed and many new companies simply go bust (not a likelihood with BT or M&S).
And smaller companies, with smaller capitalisations and thus reserves and options when things go wrong, are fundamentally more risky than the big guys. They are likely to have a less solid infrastructure, and not to be so well run.
All of which sounds a horribly unadventurous and negative approach, I know. SOMEBODY has to take a punt on the future stars. But if you DO want to do that, don’t take shots in the dark. You might just as well start putting money on the dogs… any dogs, ignoring form and odds.
Find a sector you like or are interested in - it can be computers, green technology, retail, commodities, anything - and read, read, read. Educate yourself.
If somebody offers you a wonder tip on a new internet startup price comparison website, you’d ask yourself how likely that is to survive and make money in an already crowded market, wouldn’t you?
But say somebody has just won the contract to supply tracking technology for the London area congestion charge system. And you know that it’s a system likely to be copied around the globe. You might think ‘there are possibilities here’ might you not. Think about what will be big… the tipsters almost certainly don’t know any more than you. If they did why would they be telling you after all?
Sure you want to pick the next winner but ask yourself… how are you going to separate the winners from the dogs. How likely are YOU to get it right. Next week, I’m going to the opposite extreme. Blue chips and dividend shares. Less exciting but possibly a better idea. And my tips will be on putting your finances on autopilot… to save you time.
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