Major corporations populate The New York Stock Exchange, the NASDAQ and 14 other major exchanges around the world, each with a capitalization greater than $1 trillion. But these listed corporations comprise a small percentage of public corporations, almost all of whom do not qualify for an exchange listing. Instead, stocks in these corporations are traded "over-the-counter," that is, by a network of independent dealers. OTC stocks with valuations of less than $5 per share are often called penny stocks. Potential investors should be aware that beyond being inexpensive, these stocks are different from listed stocks in ways that can make them risky investments.
What Are Penny Stocks?
The U.S. Securities and Exchange Commission defines a penny stock as "a security issued by a very small company that trades at less than $5 per share." Penny stocks have one or more of these other characteristics:
- Very small market capitalizations (basically the total value of the company's shares) of less than $50 million. Market professionals often refer to these as "nano-caps."
- Traded over-the-counter by means of "pink sheets," a term referring to the distinctive color of the paper used to list them. The term remains and still applies to small cap OTC listings, although, of course, the pink sheets themselves have disappeared; current pink sheets are digital.
- Unregulated by the SEC. All publicly traded securities must be listed and consequently regulated by the Securities and Exchange Commission unless they qualify under certain exemptions.
- Minimal verified financial information. A listed stock is required by the SEC to provide periodic financial information verified by reputable auditors and to meet numerous regulatory requirements. Exempt penny stocks have no such requirement and often provide nothing more than the name of the company, names of a few alleged executive officers and a mailing address (which could be a mail drop in a mall).
How Do They Work?
Penny stock organizations are usually set up like any other public corporation with corporate officers who lead the enterprise in search of profits. The difference between a penny stock and a listed stock, aside from the penny stock's smaller capitalization, isn't in how they work. Provided they're really functional, they work like any other corporation. The difference is in the degree of accountability: how much information a penny stock corporation provides to regulatory agencies (they may provide none) and to its investors. Penny stocks that provide 10-C forms, the kind of periodic accounts of the state of the corporation the SEC requires for all listed stocks work more like other stocks. Penny stocks that don't provide 10-C's are really unknown entities. The biggest problem with them is that you have no way of knowing how they're working – or if they're working at all. The worst case for such stocks is that the corporation consists of nothing more than an online pitch and a shell corporation in the Bahamas.
Penny Stock Trading
Normally, the best way to trade a penny stock is through an online broker. While the stocks themselves may not be verifiably solvent, the broker you use to buy them should be. These include Fidelity®, Schwab®, E-Trade® and TD Ameritrade. But there are also many different online lists of "best" online brokers provided by well-known firms like Investopedia. Any online brokerage appearing on one or more of these lists will work well.
Many more brokerages that specialize in penny stocks, however, are unregistered. Frequently, they are the most aggressive online advertisers and offer to supply "tip sheets," which are lists of supposedly undervalued penny stocks that will quickly rise in value. The SEC points out that it's risky to set up a trading account with (usually small) brokerages specializing in penny stocks that are unregistered with the SEC. As the SEC warns, registered brokers must comply with a number of rules that unregistered brokers do not, such as providing customers with
- written records of the transaction,
- a disclosure statement describing the risks associated with the investment,
- a disclosure statement showing how much the brokerage and the specific broker handling the transaction (unless it's wholly digital) make on the trade,
- descriptions of any incentives from third parties to make the trade,
- monthly account statements showing the current value of all equities and cash in the customer's account.
Provided that you buy a penny stock through a registered broker, you'll receive the same information and guarantees such brokers provide for listed shares. If you buy through an unregistered broker, what happens after the trade completes is unpredictable.
To protect yourself, NASDAQ also recommends only buying penny stocks that provide 10-K statements – the financial disclosures required for listed stocks. The organization further recommends checking to see if the company's officers are invested in the stock (this will show up on the 10-K). Company officers that are invested in the corporation have interests that align with yours: when the stock price increases, you make money together.
NASDAQ's List of Best Stocks to Buy Under $10 a Share
The minimum requirement for a NASDAQ listing is $4 per share. The NASDAQ provides no specific listing of stocks with valuations of more than $4 and less than $5, which defines a penny stock by price. They do, however, periodically provide a "List of Best Stocks to Buy Under $10 a Share," and often you can find companies in this best buy list with penny stock valuations or close to it. Because the NASDAQ is a highly reputable information source, their recommendations will be far more reliable than tip sheets provide by unregistered penny stock brokers. To find NASDAQ's most recent list of these stocks simply search online for "NASDAQ list of best stocks to buy under $10 a share." As an example, their most recommended stocks under $10 a share as of May 15, 2018, are:
- Citibank – yes, that's right, this huge corporation's stock fell as low as $1.50 a share in early 2018.
- Bank of America – another giant with a low stock price.
- Ford Motor Company – illustrating the big shake-up underway in the auto industry.
- IncrediMail, an Israeli company with a smart product that's increased in value 29 percent since March.
- Qwest Communications, with recent earnings growth of 18 percent.
- SEC: Penny Stock Rules
- FINRA: Unregistered Penny Stocks Can Spell Big Problems
- Will Penny - Wikipedia
- U.S. Securities and Exchange Commission. "Penny Stock Rules." Accessed Aug. 4, 2020.
- U.S. Securities and Exchange Commission. "Microcap Stock: A Guide for Investors." Accessed Aug. 4, 2020.
- Federal Bureau of Investigation. "Penny Stock Fraud Nets Millions." Accessed Aug. 4, 2020.
- Electronic Code of Federal Regulations. "Sec. 240.15g-9 Sales practice requirements for certain low-priced securities." Accessed Aug. 4, 2020.
- Electronic Code of Federal Regulations. "Sec. 240.15g-2 Penny stock disclosure document relating to the penny stock market." Accessed Aug. 4, 2020.
- Electronic Code of Federal Regulations. "Sec. 240.15g-3 Broker or dealer disclosure of quotations and other information relating to the penny stock market." Accessed Aug. 4, 2020.
- Electronic Code of Federal Regulations. "Sec. 240.15g-4 Disclosure of compensation to brokers or dealers." Accessed Aug. 4, 2020.
- Electronic Code of Federal Regulations. "Sec. 240.15g-6 Account statements for penny stock customers." Accessed Aug. 4, 2020.
I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.