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A Value Investor's Ultimate Nemesis: Speculative Penny Stocks

By Edited Nov 21, 2015 3 4

Stock Market

For decades, investors have always attempted to invest their money wisely. Many investors looked towards mutual funds or even bonds in order to grow their nest egg. The majority of them also leaned towards stocks. Stocks are always the trickiest types of investments due to their valuations, market caps, and future earnings forecasts. 

Fortunately, many value investors did adequate research and came across Benjamin Graham's famous book “The Intelligent Investor”. This book changed the way investing worked and introduced a new, state-of-the-art investment paradigm. Once investors followed this concept they slowly made money in the stock market over a period of time. Graham later inspired famous investors such as Warren Buffett and many others. 



According to many books written on value investing, their primary theory is all based on fundamental analysis. This is the primary key to Buffett's success. Many other value investors follow the same idea. Many critics of value investing argue that when the stock market enters into a bear market, value investing simply “Does Not Work”. 

Critics of value investing believe that if an equity is purchased at $10 a share and the market is officially in a bear market, the stock is destined to drop in share price, no matter what. In the short term the stock may sink to $7 a share, and critics of value investing believe that an investor would be throwing their money away. Furthermore, critics tend to attack value investing even more if the stock fails to pay a dividend to shareholders. 

But wait, the value investing critics are not finished yet. This is where they move their investments into another realm, a much more dangerous place, the unsafe world of speculative penny stocks. Critics of value investing typically get so frustrated with “regular stocks” that they are willing to dive head first into the Over the Counter (OTC) market. 

Little do they know, the OTC market is the riskiest way to invest money. Speculative penny stocks began getting popular decades ago. Initially, potential investors would obtain tip sheets and/or newsletters. These types of tip sheets and newsletters still exist today and attempt to convince people to buy the next big stock. Typically, they provide information regarding the sector which a company operates in, future projects, and a message from the CEO. Moreover, these tip sheets and newsletters attempt to convince the reader that they would be crazy not to own the stock. In some cases, they could even send out testimonials via email explaining rags to riches stories. These stories could show potential investors million dollar homes and expensive cars, apparently purchased by “penny stock millionaires”. 



When investors finally decide to take the plunge and actually invest their money into the penny stock, their level of risk increases astronomically. Investors fail to realize; is this company a 19 year old with a cell phone operating a business in his mom's garage? Are the statistics and information on the newsletter legitimate? Was this company once listed on a larger exchange and forced to join an OTC market because it failed to maintain certain listing requirements? 

Other potential problems that investors face when investing in the OTC market is becoming the victim of a “pump and dump” scam. This is when the executives of an OTC equity purchase gargantuan amounts of stock, artificially increase the share price, and then sell off all or most of their shares. The victim is then left with a near worthless equity and the executives make a killing in a few days due to selling the equity at the higher price. Most of the time investors are not protected by anything, not even the Securities and Exchange Commission (SEC). If investors attempt to sue the company that they bought stock in, they usually will never see the money. 

There is yet another reason investors should steer clear from the OTC market. Most of the time a penny stock will offer only so many shares to the public. Let's say someone purchases 400,000 shares of a stock. The next day it skyrockets to a new 52-week high. The investor then tries to sell the stock in a hurry. But wait, he realizes that he can't. The broker tells him that there are not enough physical shares out there to sell. Guess what? The investor is stuck with the shares and will be forced to wait until the stock plummets again. 

So, one can see that penny stocks are not just risky, but can easily persuade investors into fraudulent investment schemes. That is why value investors view penny stocks as their “Ultimate Nemesis”. There is no doubt that value investors must have patience, discipline, and enough knowledge to understand what works and what doesn’t. Many successful value investors have invested in penny stocks in the past and lost their entire investment. From now on, if one thinks about investing in penny stocks they should go back to Benjamin Graham's philosophy and do whatever they can to completely avoid their “Ultimate Nemesis”.


Value Investing: From Graham to Buffett and Beyond
Amazon Price: $21.95 $12.17 Buy Now
(price as of Nov 21, 2015)


Oct 8, 2014 9:04pm
I'm always reminded of the scene from "Wolf of Wall Street" where the guy who runs the Investor Center is telling Jordan about the penny stock Aerotyne Inc., and he can't even describe what the company does. "You call the company's phone number and their mom, Dorothy, answers the phone, and she's just the sweetest lady ever". I wonder how many of these penny stocks are Aerotynes. Don't get me wrong, many of them are legit and many of them will grow to be good companies. But a handful out of a huge number of them? Are you willing to take that gamble?

Dividend growth stocks are a much better--and safer--place to put your money. I wrote an article about them here: http://www.infobarrel.com/Dividend_Growth_Investing_The_Path_to_Financial_Freedom

Before anyone says anything, I got DubeluWriter's permission to post that. It truly is a strategy that is the polar opposite of penny stock "investing".
Oct 13, 2014 12:47pm
True, many penny stocks are just like the companies portrayed in the film. I read your article on dividend growth investing and I strongly recommend it.
Nov 16, 2014 8:12am
Many years ago, I read a book on investing in penny shares (which I still have). At that time, Polly Peck was touted as being an example of how much money you could make from them. It's not doing so well now - it went bankrupt, the CEO fled to Cyprus, and it caused a reform in company law.
Dec 7, 2014 3:36am
It is ok to invest in small amounts, be in your reach,otherwise life will be difficult.
I saw one private trading company having 20 employes gone bankrupt, the owner lost all of his fortune and workers were not paid for their jobs,until the business closed down.

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