What are penny stocks, and do they make “cents” for your portfolio?

Penny stocks are the black licorice of the investing world: craved by some and avoided by others. And like licorice, penny stocks are somewhat of an acquired taste.

On the surface, penny stocks look like the less expensive version of equities trading on the market. Probe a little deeper though, and you’ll see the nature of these investments is quite different. While a $0.30 price change may not make much of a difference for a stock worth $72, for example, the same change in the price of a penny stock typically worth $0.50 cents could be significant — substantially increasing the value of your investment or potentially wiping out your holdings. Here’s what else you should know about penny stocks.

What are penny stocks?

When a small company first goes public, it often starts as a penny stock. Despite the name, penny stocks are stocks that trade under $5 per share, primarily on over-the-counter (OTC) market exchanges. OTC trades are those that occur between two investors, without an exchange supervising the trade as an intermediary.

While some of these companies are startups, others may boast world-class, seasoned leadership. It all depends on the stock. You can find a wide variety of industries and geographies among these low-price equities.

If there is one thing to remember about penny stocks, however, it’s this: They can be inexpensive for a reason. That’s not to say penny stocks have no value or can’t become something more substantial. Rather, penny stocks are priced low because these companies can be highly speculative. On occasion, a stock may also fall into penny stock territory if it was delisted from a major exchange. This may occur because the business was unable to meet the minimum listing requirements.

Penny stock sectors

There are penny stocks in every sector, but some sectors have more offerings than others. Here are some of the sectors where you could find penny stock listings:

• Biotech
• Blockchain
• Energy
• Gold
• Cannabis
• Mining
• Artificial intelligence (AI)

How do penny stocks work?

While penny stocks may be affordable to purchase, their price is not their most defining feature. Rather, it’s the regulatory attention they face — or lack thereof. OTC markets are not as strictly regulated as major exchanges, meaning the companies that list there do not face the same level of official scrutiny. On major exchanges, for example, companies can face penalties for something as small as missing a filing deadline.

Unlike major market equities, however, stocks on OTC markets generally do not receive the same amount of attention. Penny stock companies have even been known to rely on social media influencers to help raise awareness about their businesses. While popular, these influencers may lack the necessary expertise to share investing advice.

Although the OTC market can offer companies an easier path to go public before graduating to one of the major markets, the reverse is also true. If a stock listed on a major exchange falls below $1 per share, the exchange may initiate a delisting process. If that happens, you’ll be able to find a record of it on the System for Electronic Document Analysis and Retrieval (SEDAR), a site packed with easy-to-access and up-to-date information on every public company.

Why do people invest in penny stocks?

• Low cost: You can acquire a large block of shares for a small investment.
• Chance for outsized returns: While small changes in share price rarely move the needle for stocks on major exchanges, fluctuations can have a significant impact on the value of a penny stock.
• Chance for a quick gain: Because their valuations can change so quickly, penny stocks may offer investors the chance to make a lot of money in a short time.

How much money can you make with a penny stock?

Sometimes, a lot. Because you can buy so many shares for so few dollars, you have the potential to rack up some big gains quickly — that is, if you invest in the right stock. A $0.25 gain per share may not be that significant for stocks on the main exchanges, but for some penny stocks, it could mean a double-digit return, depending on the number of stocks you own.

How much can you lose if you trade penny stocks in Canada?

As much as you have invested in them. Investing in penny stocks means accepting a higher level of risk. While there may be some good companies to invest in, others will not survive.

Risks of penny stocks

Difficult to evaluate:

Penny stocks typically do not face the same pressure to meet standard reporting requirements, which may make it difficult to evaluate the business in question.

Hard to sell:

Buying a penny stock is easy. Selling it again might not be. Penny stocks are not considered very liquid — meaning they can go extended periods with limited or even zero trades. Investors may therefore find it difficult to locate a new buyer when they’re ready to sell.

Prices can be unpredictable:

Finding another investor who is willing to pay you more than you paid may be more difficult when that stock is traded OTC. Likewise, if a stock trading on a major exchange falls into penny stock territory, it could be delisted and drop in value.

Scams:

The limited regulatory oversight and reporting requirements means penny stocks can be more susceptible to fraud and bad actors.

What to know when you are looking to buy penny stocks

Before you invest in anything, it’s important to conduct thorough research. It’s even more important when considering penny stocks. Dig into the company’s finances. Learn what you can about the management team. And then look beyond the company itself — both at its competition and the industry as a whole.

While there’s no limit to how much you can invest in penny stocks, you may want to be careful. Putting 20% of your portfolio into a blue-chip equity or an index fund might make sense for you, depending on your goals, but doing the same with a penny stock could have a negative outcome. Remember, you’re betting on a single company with a high-risk profile.

A few other considerations:

• It can be risky to buy multiple penny stocks in an effort to diversify your portfolio.

• You might want to monitor these investments closely. The potential for volatility is significant.

• Market hype can be misleading.

• Stocks with higher trading volumes are easier to buy. This could matter when the time comes to exit a position.

• Investors will sometimes buy more of a stock as it falls in value to effectively lower the average price per share they paid for their holding. Penny stocks are typically more volatile than large-cap equities, making this strategy riskier.

Where are penny stocks traded in Canada?

Canadian banks all offer platforms that allow you to buy and sell penny stocks. Additionally, there are non-bank owned digital platforms that can accommodate OTC market trades. Here are four ways to trade penny stocks in Canada.

1. OTC

   The OTC Markets Group, which operates an electronic bulletin board to buy and sell penny stocks, is the most common way these equities are traded. Its top-tier market is called the OTCQX. The OTCQB, or Venture Market, is a second-tier market made up primarily of early-stage companies showing signs of growth.

2. Using “pink sheets”:

   The OTC Markets Group has a third tier called OTC Pink, or Open Market. This is where equities that don’t qualify for the top- or mid-tier markets are listed. They have the very lowest disclosure requirements among OTC equities.

3. Directly between brokers

   Some small brokerage firms may support penny stocks that are listed on OTC markets.

4. Major exchanges

   While you may not find many penny stocks on major exchanges like the TSX, NASDAQ and NYSE, some may be found there if they meet certain regulatory standards.

How to buy penny stocks in Canada

If you want to buy penny stocks with TD, you’ll need to open a TD Direct Investing or TD Easy Trade account. Before you’ve made an investment, you may want to spend some time exploring the Easy Trade platform and the various tools it offers investors.

Once you’ve done your research, you can place buy and sell orders on the brokerage platform. Again, if you choose to invest in penny stocks, it can help to monitor them regularly after your purchase. You can also set up a stop-loss order if the stock is liquid, which could limit how much you might lose on an investment.

The history and future of penny stocks

Penny stocks have a somewhat checkered history. On occasion, they’ve made investors a pile of cash, only to see it evaporate just as quickly. In 1989, for example, a Calgary mining company named Bre-X Minerals launched an initial public offering (IPO) at $0.30 per share. The geology of the site offered potential, but there wasn’t much else there. Six years later, Bre-X claimed to have struck gold. Retail and institutional investors quickly poured money into the stock, pushing it up to $286 a share in 1996.

After offering to buy 15% of the company, the mining company Freeport-McMoRan surveyed the site and found the so-called gold rush had been a fallacy. It turned out, Bre-X geologist Michael de Guzman had dropped gold from his wedding ring into the original samples, and had continued to do so for two years with gold he bought locally.

Of course, 1989 was a long time ago. Advances in technology have made company information more readily available, in part via high-quality trading platforms. Regulatory changes have also made a difference and the market has grown more efficient as a result. Still, the lesson remains.

For other famous investing stories take a look at: Spooky tales of speculation.

Bottom line: Tread carefully

Ultimately, if you tread carefully and do your research, you could find penny-stock companies with potential. No one knows when the next Amazon will appear, but there’s a chance it’ll start with a sub-$5 share price. The chance that the average investor will find it and cash in, however, is somewhat slim. After all, many private companies have IPOs priced much higher than the penny stock range. If you do invest in a penny stock, it can be important to consistently monitor your investments for early signs of trouble.

FAQs: Penny stocks

How do you trade penny stocks in Canada?

To invest in penny stocks, you’ll need to open a brokerage account with a Canadian securities dealer and deposit money into your account. Each platform is different, but large financial institutions typically have a lot to offer in terms of research and tools.

Can you buy penny stocks in a TFSA?

In Canada, stocks traded solely on OTC markets cannot be held in registered investment plans like TFSAs and RRSPs.

Are penny stocks worth buying?

Ultimately, you can earn a positive return on any stock investment, regardless of its share value or market capitalization. Penny stocks are riskier, however, in part because they’re more difficult to research and evaluate.