Penny shares are typically growing companies with limited cash and resources. In other words, most penny shares are high-risk investments with low trading volumes and limited attention from investors. Some brokers stipulate that a penny share must have a value below some limit, whereas others may specify an upper limit on their market capitalisation.
The essence of these companies are that they will most probably have only a small amount of tangible assets and a short history. This is in contrast to shares in large blue-chip companies which will have the stability of a large amount of assets and a long trading history to fall back on. This is why penny shares are such a volatile proposition, the same thing which makes them so exciting.
Young or New Issue Shares
Most penny shares and small cap stocks will be young companies which have been trading for a short period of time. Most companies would have at one point started out as penny shares before they grew. The potential of a penny share can be limitless.
These are companies which were once performing very well and have now fallen out of favour. With the share price tumbling, these companies then offer the potential that they can be turned around, usually through business restructuring.
These are shares that rise and fall in value according to the economic conditions or business cycle. Investors will ideally look to invest in the stocks at the bottom of the cycle before the upturn.
These are stocks that tend to do well in periods of economic depression. They are generally companies whose products or services enjoy steady demand. Defensive shares can be found in industries such as food and utilities - things that consumers still use in bad times.
Many penny shares are listed on the Alternative Investment Market (AIM). This is a market which opened in 1995 specifically to give smaller, younger companies access to the public markets and helps to increase their profile and credibility as well as making it eligible for a number of tax benefits.
Some of the companies may be listed on the London Stock Exchange's Main Market - the UK stock market. The main market differs from AIM in that the company would need a minimum market capitalisation as well as having a minimum of 25% of its shares in the public domain. The LSE will also only admit companies with a 3 year historical trading history. The AIM is more lightly regulated.
A further market where Penny Shares may be traded is on the Off Exchange (OFEX). This is an independent market which concentrates on small and medium enterprises and will also include many companies from outside the UK and around the world. OFEX is not a regulated market and companies on it are officially 'unlisted', although they may make it to the Main Market eventually.
Penny Share investing can be very exciting. It is a great buzz to watch a stock rise in value from a few pence up to a few pounds. However, the possibilities of growth can often be matched by the inherent risks.
Penny shares generally have a thin market. A stock priced at 10p may rise 50% on good news, whereas a larger blue chip stock share price will not. Conversely, the penny share can fall more sharply than the larger stocks. Its price at any given time may in fact bear no relation to the stock's underlying value.
Because penny shares are thinly traded, they can be targeted by people wishing to manipulate the price. The internet has made it easier to perpetuate these penny share scams. The way it is done is by pumping and dumping. Unethical individuals or organisations drive interest in the shares by using websites, press releases and e-mails. The increased demand pushes up the value of the shares before the organisation or individual sells them at a profit. If you are considering buying penny shares you need to be vigilant of these factors.
One of the most glaring examples of a penny share being pumped is the stock LEXG, a lithium exploration company. This has been named as the biggest penny stock promotion of all time. It was promoted on a massive scale, and at one point had a market capitalisation of over $300 million. Its revenues, on the other hand, posted months earlier were nil!
Liquidity is the ease with which an asset can be turned into cash. Penny shares usually have low liquidity which means that there will be a great difference between its bid and sell price. As there are usually few buyers for penny shares, the sell price will fall until a buyer can be found.
Be prepared to lose money if you invest in penny shares. It is recommended that you already have experience in dealing stocks and shares. Some schools of though recommend that you do not invest more than 20% of your entire share portfolio in these speculative shares. If you cannot afford to lose any of your capital, have little or no assets, or you are a student or not in steady employment then you should not be thinking about dealing in penny shares. You should never borrow money to invest in penny shares.Some people see them as 'hobby' stocks and invest in them using their spare cash.