Investing in Penny Stocks with Pink Sheets

Tiny companies are a great way to make a fortune off of the stock market. Every trading day one thing’s almost certain: the biggest gaining stocks are bound to be penny stocks. The profit potential of penny stocks has been turning heads for some time now, but before you decide to plunk down your money on a small stock, there are some things that you should keep in mind…

It’s absolutely true that penny stock investors can make very quick gains. Synutra International, Inc. (NASDAQ: SYUT) is a great example of a penny stock. This dairy-based, nutritional-products company has jumped from a little Bulletin Board operation to a billion dollar corporation. The company finally graduated from Over-the-Counter status to the NASDAQ Stock Market bringing with it 113% gains in less than two months.

This happens all the time and it’s how some of the best investors in the world became the richest investors in the world. Buying some shares for pennies on the dollar and selling at $10 or $20 is possibly the fastest way from being a hobby investor to a super investor.

In fact, penny stocks are a compelling investment even when the economy’s not so hot. According to a research done by financial news outlet The Motley Fool’s Ilan Moscovitz, “[During a recession] small stocks outperformed T-Bills, bonds, and the S&P about two-thirds of the time — and they did so by a ridiculous margin.”  This is all well and good, but do you really think that you have access to these lucrative companies? Not really. The problem is many of them aren’t even traded on a major exchange.

Over the Counter Stocks Can Make Over the Top Profits

Generally speaking, any stock that doesn’t trade on a major exchange is considered an over-the-counter (OTC) stock… that includes both Pink Sheets stocks and OTCBB stocks.

One of the questions we get a lot here at Penny Sleuth HQ is, “How exactly do I buy penny stocks?” The truth of the matter is that buying penny stocks isn’t much different from buying any other stock out there.

Two places where you will see a difference with investing in penny stocks are in the commissions you pay and your ability to use margin, or borrow shares from your broker. Most brokers have a slightly different fee structure for stocks that cost less $1. More on that later…

How to Pull Off Penny Stock Profits

OTC stocks frequently bank mind blowing returns for investors. Just look at Like Explorations Group (OTC: EXGI), a company that acquires and manages parking lots and garages in New York City. Its shareholders just banked 2,521%. Or Zagg (OTC: ZAGG), a company that makes protective coverings for iPods – in the last few months, its small group of owners has made 827% gains.

One of the best ways to find penny stocks with this kind of gain potential is to look out for “growth catalysts”. That’s because without some big event or monolithic development coming down the road, there’s no reason for investors to care about these tiny companies.

You see, the majority of investors are only interested in making 5%–10% per year. That’s pretty much the maximum you can expect to gain if you are investing in blue chips. Here at Penny Sleuth, we view the stock market a little differently.

We want the money multipliers — double-, triple-, even quadruple-digit gains that I told you about just a minute ago. For that to happen, we need some kind of spark to set our penny stocks apart from the rest. After all, there are currently over 6,000 to choose from.

So, what kind of catalysts can make a penny stock pop? Let’s look at a couple big ones:

• Commercialization — After years of research and development, and sometimes painstakingly long clinical trials and efficacy tests, there comes a time in any successful start up company’s life when it needs to actually manufacture and sell its products or services. Just take a look at what happened to Tata Motors Ltd. (NYSE: TTM)…

As you might already know, this was the growth story of last year, and it continues to today. Tata is the Indian car giant that made its mark on the global economy, when it released the world’s cheapest car.

In March of this year, the company commercialized a new product. It started selling the Tata Nano in India. Investors were so excited by this car design, they started buying enormous amounts of Tata stock. Since the company started pre-selling the car, shares are up 165%.

• Buyout Candidates — Sometimes, it’s as simple as waiting for a larger competitor to buy the penny stock. When one company buys another, they agree on a price. Many times, that price is much higher than what the soon-to-be-purchased company’s share price is currently trading. This gives those shareholders an instant gain.

A few weeks ago, I discussed the consolidation of the soda industry. Both PepsiCo Inc. (NYSE: PEP) and Coca-Cola Inc. (NYSE: KO) are buying out their bottling operations to save on expenses and double spending.

Pepsi is in the process of buying its two largest bottlers: PepsiAmericas and Pepsi Bottling Group. Shares of both of these companies popped more than 22% the day it was announced.

From their March lows, PepsiAmericas is up 67% and Pepsi Bottling Group is up 94%.

• Legal Battles — The last of the major catalysts is court rulings. In many cases, a simple ruling can make or break a penny stock. Hardly any company has been entrenched in the courtroom like TiVo Inc. (NASDAQ: TIVO).

We wrote about TiVo back in December 2007. Its revolutionary digital recording technology is both a huge moneymaker and a legal nightmare. You see, plenty of other competitors claim rights to certain patents TiVo profits from.

It takes a tech geek to decipher the differences between most of its intellectual properties, which isn’t usually a prerequisite for a judge. For the last five years, TiVo has been tied up in court with its competitor EchoStar Communications Corp, now part of Dish Network Corp., over a patent dispute. The court finally ruled in favor of TiVo, rewarding the company $103 million plus interest.

Upon the day of the ruling, shares of TiVo jumped 53%. This gain sent TiVo’s stock over $11 per share and out of penny stock land. That just a drop in the bucket of what a lawsuit ruling can do for a company. Imagine what $103-plus can do for an even smaller company…

These are just four types of things to consider when thinking about buying a penny stock. But even if you do have the perfect catalyst lined up, that’s only the beginning.

Pile Into the Pink Sheets

Of the OTC stocks out there, there are two places where they can trade: Pink Sheets, LLC or the Over-the-Counter Bulletin Board (OTCBB). Until recently, it has been nearly impossible to get good information about companies like these. Until a few months ago, the pink sheet stocks offered virtually unaccountable information. No required filings, inaccuracies rarely corrected, and even shell companies… Until now…

The pinks have released a new classification system that helps investors sort out the companies with little or no information, leaving you with only credible companies with enough info to make smart investment decisions.

The top level of classification is called PremierOX. This level ensures investors that the companies listed here sell for at least $1 per share, have at least 100 shareholders with a minimum of 100 shares each, as well as meet the requirements of all the major exchanges.

The second tier is called PrimeOX. This level requires virtually the same except there is no minimum share price and only 50 shareholders with a minimum of 100 shares to gain entry.

The third is for international companies. This level, International OTCQX, is currently being broken into two separate categories, Int’l Premier OTCQX and Int’l Prime OTCQX. The requirements here are basically to meet those of the company’s national exchange (a UK company would have to meet the London Exchange’s requirements). The second prerequisite is to have their filings available in English.

This new classification system makes all of us at Penny Sleuth ecstatic because it gives more insight into the relatively unexploited area of true “penny stocks.”

A Safer, Premium Way to Play the Pink Sheets

A major concern we’ve been hearing about investing in stocks listed on the Pink Sheets is accidentally stumbling onto an illegitimate company that could instantaneously drop 50%, 75% or even 100%. We’ll help you avoid those sub-penny shell companies that do nothing more than issue press releases and more shares of worthless stock.

First, some background information is necessary. You see, the Pink Sheets is not an exchange like the NASDAQ or Amex. It’s only a quotation service. The only requirement a company faces on the Pinks is that it must have at least one market maker quoting its stock. Financials do not need to be disclosed.

Even on the OTCBB, companies are required to keep current filings with the Securities and Exchange Commission. This lack of information can make investing in the Pink Sheets downright frightening.

But there is a very small group of stocks on the Pink Sheets you need to know about, especially if you have never traded on the Pinks before. It’s a new premium listing service called OTCQX. The new listing service includes three different levels, each with specific requirements for the companies.

As I mentioned earlier, the top tier is called PremierQX. These are securities that trade for a minimum of $1 and meet all of the requirements to be listed on a national stock exchange. This means the companies are required to post quarterly and annual reports, as well as interim information that could affect share prices.

PrimeQX stocks, the second group, must also meet the requirements to be listed on a major exchange.

However, the stocks listed in this group do not have to trade for the $1 minimum. International OTCQX stocks, the third category, must meet requirements of their foreign exchange and make their reports available in English. All three groups require the companies to maintain ongoing operations, keeping away any shell companies that are constantly changing strategies.

Together, these three lists make up the safest investments on the Pink Sheets. It’s a great place to start looking if you’ve never invested in these types of companies before. The OTCQX commenced trading on March 5, 2007 with only seven companies (you can view a complete list of OTCQX companies at www.otcqx.com). But more penny stocks are being added to the list every week as they meet the requirements. Of course, being added to the list is great exposure for some small, legit firms.

Penny Stock Stumbling Blocks

Being listed on the OTCQX doesn’t make a stock a good investment in and of itself. Just like any company that’s listed on a big exchange like the NYSE or NASDAQ, OTCQX stocks need to be analyzed based on their merit as investments. That said, there are a couple of factors that make stocks that trade on the pink sheets – even the OTCQX – act differently than those on major exchanges.

First up is volatility. Volatility for penny stocks is double-edged sword: while it means that penny stock investments can be comparatively riskier than their blue-chip counterparts, it also provides the opportunities to profit 100%, 500%, even 1,000% in a short period of time.

In penny stocks, volatility is largely the result of low trading volume. Penny stocks have less exposure to big investors because of their tiny market capitalizations, which in turn limits the amount of daily transactions that occur in their stock.

Having low trading volume isn’t necessarily a bad thing – it’s just something to be aware of.

Another thing to keep in mind when you buy penny stocks is your broker commission. It’s not uncommon for brokers to use a special commission schedule for stocks that trade under $1 or that trade on the Pink Sheets or OTC.

While that generally means you’re paying slightly more in commissions to your broker when you buy penny stocks, your commissions shouldn’t add up to a significant chunk of your overall position in a stock. If they do, you should rethink the size of your investments.

If you want to learn more about Pink Sheets stocks, the Pink Sheets website offers a treasure trove of information – namely, stock quotes for these tiny companies, financial data, and charts.

5 Profitable Penny Stock Tips

If the idea of investing in penny stocks still sounds alluring to you, here are 5 pieces of investment advice that could mean the difference between making profits and losing your shirt in these hectic markets…

1. Know What You Own. In the world of Wall Street, whether you’re investing in penny stocks or blue chips, one of the biggest rules is to “know what you own.” What does that mean? You should know the company you’re investing in inside and out. Know its business. Know how it makes money. Know its management. But as important as this rule is for any investor, it’s doubly important for investors in penny stocks! That’s because with penny stocks, share prices can change quickly if you don’t keep a handle on them. So know what you own and your investments won’t end up owning you.
2. Don’t Get in Over Your Head. When you see a hot penny stock that’s ready to take off, it can be hard to keep from cashing out your 401(k) to buy as many shares as you can…getting in over your head with penny stocks is an almost sure way to get burned. Even though penny stocks can make you some serious money, they’re volatile — and that means you shouldn’t put more than 10% of your portfolio on the line. What’s the smart penny investor to do? Set up an account (or a section of your main brokerage account) for just penny stocks and load it only with money you’re prepared to lose.
3. Be a Skeptic. Just because a company has an interesting new idea doesn’t necessarily mean it’s a good prospect for your portfolio. The key is… Do you think that it can monetize its idea? If that answer isn’t immediately clear, it’s time to dig a little deeper into that company’s prospects. Thinking outside the box is a great way to get innovative companies on your radar, but being a skeptic is the only way to make sure that translates into gains for your portfolio.
4. Think, Then Buy. When you’re ready to buy shares of a penny stock, make sure you take a second to think about what you’re doing. All too many first-time penny investors take the jump on just a few shares of a penny stock without realizing how much the size of their investment will affect their returns. Think about it this way… You’re an investor who sees an attractive stock for $1 per share. You don’t have a large portfolio yet, and you don’t want to take too much of a risk, so you buy just 50 shares for $50. Turns out you picked a winner that made 40% in just a week — $20 of pure profit. You sell and rejoice in your penny stock success. But wait…is that celebration justified? You’re forgetting about those $10 execution fees you paid to buy and sell that stock. That’s $20 altogether. Looks like you only broke even, despite the fact that you had a stellar stock. When you’re buying penny stocks, make sure you’re buying a large enough quantity that account costs (like execution fees) don’t eat up your profits. You can find out your minimum returns to break even with this: Execution Fees/Stock Acquisition Price x 100 = Break-even Gain (Percent) Needed
5. Don’t Get Greedy. Lots of penny stock investors see 200%, 500%, even 1,000% gains on a stock but still end up losing money in the end. It’s not because they didn’t plan their buys properly…it’s because they got greedy! It doesn’t matter how much money a stock makes if you’re not ready to press the button and realize those gains. That’s why you need to set solid exit points for any penny stock you buy.

It’s human nature to want to hold onto an investment as you see it climb with no end in sight, but doing that is a great way to miss out if that trend turns around. When you analyze an investment, think about a logical exit price and sell for that. Picking solid exit points will become easier as you develop your investing chops.

Your Penny-Sized Path to Profits

Hopefully, this little primer on investing in penny stocks has shown you that the learning curve for these kinds of investments isn’t nearly as bad as it seems.

Penny stocks can be a risky investment to be sure, but if you make informed decisions and approach your penny investments with the same thoroughness that you’d use in your other investments, you too can unlock a whole lot of profit potential. And don’t worry, at the Penny Sleuth we’ll be here to deliver your daily dose of stock market sanity.

Sincerely,
Jim Nelson,

Managing Editor Penny Sleuth

P.S.: We also put together another special report: 3 Little-Known Powerhouse Stocks that are primed to go through the roof. Check it out and capitalize on the investment potential of these stocks.