If you’re looking for a way to diversity, strengthen, and enhance the potential growth of your portfolio’s value, consider acquiring two kinds of securities: penny and small-cap stocks. But first, be warned. Despite the fact that many writers, news outlets, and academics use the terms interchangeably, they are certainly not the same. Boosting the value of your portfolio is an effective way to increase net worth.
So, what’s the difference between the two types of securities? A penny stock trades for less than $5 per share and is issued by a company whose total market capitalization (the aggregate value of all its shares) is less than two-billion dollars. A small-cap (S-C) stock is issued by a corporation whose total capitalization is less than two-billion dollars, but there is no restriction on the price of its shares. That means that all penny stocks are small-caps, but not all small-caps are necessarily penny stocks. Here are some of the pros and cons of putting some of each type into your portfolio.
Pro and Con: Volatility
The securities markets are unpredictable places. Prices of any company’s shares can fbeg without notice. But in the real world, large-cap and blue-chip shares rarely surge or tank very quickly. Stable, large corporations with long histories of delivering goods and services to a global marketplace tend to rise and fall in price rather slowly.
For pennies and low-priced S-C securities, those rises and falls can be rapid-fire affairs that leave investors with their jaws on the floor. It’s not unusual, for instance, for a $2 security to drop off the board, never to be seen again.
Likewise, and here’s the lure, those same shares can shoot to $4, or higher for gains in excess of 100 percent in the same amount of time. So, volatility is both a pro and a con when you look at the situation that way. Here’s a work-around for the downside of owning these volatile securities: Diversity, do research, choose carefully, and never invest too much money into any one security, especially low-cost ones that come with built-in volatility.
Pro: Low Cost of Entry
Investors, especially those new to the markets, are drawn by the extremely low cost of entry offered by $1, $2, and $5 price tags. For less than $500, just about anyone can open a brokerage account, purchase a few hundred shares, and begin playing the stock market. Yes, the risk level is high, but if your purchases are spread around 10 or more companies, you can largely avert much of that risk.
Con: High Risk
Some very low-capitalization companies are unknown quantities to the investing public. They don’t trade on the major exchanges, are only available via the over-the-counter marketplace, and have little or no track record. There’s a way around this disadvantage. By doing extensive research, you can single out companies that have at least two or three years of successful operation, stable management teams, and solid financial results.
Pro: High Potential for Outsize Returns
Where there is the possibility of risk, there’s usually an equal chance for reward. When a company whose stock is trading at the $1 level moves up to $1.50, that half-dollar rise represents a growth factor of 50 percent. A $1,000 investment shoots up to $1,500 in a single session, assuming the movie takes place in one day. This high potential for large returns is what draws people to the low-cap market in the first place.
Pro: Easy to Diversify
If you purchase blue-chips, many of which cost in excess of $500 per share, it’s hard to diversify unless you have a vast source of funds. With lower-cost issues, however, it’s simple enough to spread out your funds and acquire 20 or so shares of a dozen or more corporations. Perhaps the single most attractive thing about this approach, particularly for new investors, is ease of diversification.
Con: Not All Brokers Offer Them
There’s only one way to get around the fact that many brokers refuse to deal with low-cost stocks: find one that does. But even when you do locate a low-cap-friendly broker, you face the very real prospect of higher commissions and the inability to use convenient, protective ordering methods like stop-losses. There’s a lesson here to always ask a brokerage representative before signing on the dotted line. Make sure they allow all order types, don’t enforce higher than normal commissions on low priced issues and allow you to purchase any over-the-counter shares you desire.
Pro: Can be Part of a Diversified Portfolio
If you already have a portfolio that includes blue-chips and other common types of holdings, consider adding S-C, or reviewing a guide from Warrior Trading on adding penny stocks to the mix for a dose of diversification. Investors often place non-traditional assets into their portfolios for this simple reason. That’s why things like gold bullion, silver, low-priced shares, commodities, and hard assets are often part of a well-rounded investment portfolio.
Con: Pink Sheet Stocks are Inherently Risky
A large percentage of low-priced issues are not listed on the major exchanges but only on the OTC, or over-the-counter board. There is no physical trading location because all OTC transactions take place electronically. The OTCBB, or OTC bulletin board is the platform from which these securities are sold to the public. In the old days, these listings were printed on pink paper to make them readily distinguishable from big-board securities. Today, OTC listings are still called pink sheets even though there are no paper lists. The thing to remember about pink sheet offerings is that they are all inherently risky, and not just because they are small.
Being on the pink sheets means the company is unable to meet the more stringent requirements for being listed on a major exchange. They’re either too new, have no financial history to speak of, or can’t pass the auditing requirements to make it into the big leagues. How can you, as an investor, overcome this obstacle? Simple, stick with the major exchanges.
There are plenty of under-$5 offerings to choose from, all the companies went through the strict financial audit to get there, and the risk level is much lower than OTC, or pink sheet issues. You’ll still have to perform your due diligence by engaging in research, but at least you have the peace of mind that what you are about to buy has been vetted by one of the exchange’s auditors.