The skinny on penny stocks

Most penny stocks don't trade on a stock exchange but rather an electronic over-the-counter quotation system such as the Pink Sheets or OTC Bulletin Board. The Pink Sheets is a privately owned centralized quotation service that collects and publishes the bid and ask prices of securities from selected stock brokerages known as "market makers," the SEC says. The name "Pink Sheets" comes from the color of paper that quotes were historically printed on. These securities are too small to qualify for listing on other exchanges such as the New York Stock Exchange or Nasdaq.

The OTC Bulletin Board, or OTCBB, is an electronic quotation system that displays price quotes for over-the-counter companies or those not listed on exchanges. It is operated by Nasdaq and overseen by industry regulator FINRA, or the Financial Industry Regulatory Authority. Unlike companies on the Pink Sheets, companies quoted here must be fully reporting and be current on required SEC filings. But there are no requirements for minimum price or market capitalization as there are for companies traded on the major exchanges.

Pink Sheets reputation

However demonized they've been, there are many legitimate, sound companies trading on the Pink Sheets. Such a quotation system for the smallest of the small has actually filled a gap, creating a marketplace for companies that otherwise would not be able to trade.

Jack Norberg, chairman of Standard Investment Chartered Inc., of Costa Mesa, Calif., which trades in microcap stocks, suggests that "just because a company does not have 500 shareholders, doesn't mean it's not a good place to invest for the long term."

"The key research effort is to separate the weak promotional companies from the strong shy types," Norberg says.

Still, given the lack of information and lack of liquidity, most investors should steer clear of Pink Sheet companies unless they have the time and skill necessary to adequately research the companies trading there, Stark says.

"There's no reason to rush into any investment. Period. If you miss a few points on the upside because you were careful and thoughtful, you're still going to be better off," Stark says.

To help investors, the Pink Sheets added some disclosure in August 2007 in the form of three categories for companies being quoted in order to provide investors with more information, according to its Web site. They are:

  • Current information for companies that do submit regulatory filings and make them available.
  • Limited information for companies with financial reporting problems or in financial distress or bankruptcy.
  • No information for companies unable or unwilling to provide disclosure to regulators, exchanges or the Pink Sheets. It may include defunct companies or companies with questionable management and market practices.

The Pink Sheets also have a "caveat emptor" category, which includes companies under investigation for fraud, or those with spam campaigns or questionable promotion activities. Stocks in this category will have their quotes blocked by the Pink Sheets, meaning that stock quotes for these companies will not be listed.

Penny stocks or just stocks?

With a major pullback in stock prices through early March of this year, many companies have seen their stock prices fall to less than $1 a share. This includes former blue chips such as Citigroup and AIG, as well as Office Depot, which all saw their stock prices decline over a variety of financial concerns.

Although each of these companies fell below a dollar, none of them met the traditional definition of a penny stock. For one, all of these companies trade and continue to be listed on the New York Stock Exchange, all are required to file with the SEC and information about them is readily available.

"No matter whether they're public or private, regulated or not, all businesses face the risk of failure. While it makes sense for most investors to buy an index of many companies, those who are going to invest in an individual business have to do their homework. That means digging into a public company's filings, not just accepting them at face value," says Patten.

Given the beating that many investors suffered during 2008 and early 2009, there may be the inclination to try to make up for lost capital by investing in lower-priced companies where a small move in share price can result in big gains. This is dangerous territory, especially in the penny stock arena.

"Unfortunately, this environment is probably a bountiful one for hucksters promising massive short-term gains to hopeful investors who are desperate to regain lost wealth. But keep in mind that you're likely to just end up surrendering part of your remaining wealth to them," Patten says.

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