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That is the ultimate attraction of penny stocks. There is a reason penny stocks are often referred to as penny dreadfuls. Yet many average retail investors simply cannot resist the delightful prospect of massive percentage gains in a matter of days, and sometimes in a matter of hours. These investors ignore the plentiful advice to avoid using anything other than excess disposable cash to gamble on this kind of investment. Gambling, they tell us, is what investing in penny dreadfuls really is; nothing more than a trip to the Casino and a roll of the dice.
Why then are penny stocks so popular in share markets world wide? These companies are typically very small and are engaged solely in exploring for minerals. A single find or even something as little as a positive geological report can send the share price soaring in the expectation it could be the next big winner. At the close of , you could have invested in Minemakers — a Perth based phosphate exploration mining company -- for around twenty cents a share.
In the minds of many investors, the opportunities for ten-baggers are more plentiful in the wonderful world of penny stocks. The second reason they are so attractive has to do with how greed can trump rational thought. When greed steps in, it is easy to believe the potential for capital appreciation is higher the more shares you own. We forget about risk and focus solely on reward, salivating at the prospect of finding a share like MAK that could make us rich.
And yes, there are other short-term success stories with other penny stocks. Greed also allows us to fool ourselves into believing we can do what most investors cannot and that is time our buys and sells perfectly.
We look at a chart like the MAK and GWR examples and when dreaming about how much we could make if only we could find more shares like those, we calculate the profit assuming we bought in at the low and sold at or near the high. Also based in Perth, Great Western Resources is engaged in exploring for iron ore and gold.
The charts of both these companies display the main reason many refer to penny stocks as penny-dreadfuls. They can fall as rapidly as they rise. Investors that bought in on these dips to catch the rising tide ended up losing big when the tide rolled out. Does this mean you should avoid all penny stocks? Philip Fisher, considered by many market experts to be the father of growth investing, had this advice for investors in his classic investing book, Common Stocks, Uncommon Profits: They were harder to research without the reporting requirements we see today on the exchanges, but what Fisher was saying is the low price of a stock does not mean the stock lacks the potential for growth.
And there are real success stories with penny stocks. Here is a ten year chart of one such success, CuDeco Limited: CuDeco CDU is engaged in the exploration and evaluation of mining properties, mostly in copper.
The Internet has revolutionised sharemarket trading in many ways and one is the advent of the many stock forums and discussion boards. There you will find some average investors, just like you, who are eager to share the results of their own research into a company with others.
Mining has been the major source of penny stocks in Australia for years and on a good forum you will find individuals who have expertise in mining technology. However, you will also find something else on those boards — stock spruikers and day-traders.
A spruiker is essentially someone whose job is to promote something with tales that often sound too good to be true. Day traders sometimes frequent those boards as well for the same purpose — pumping up a share price regardless of the real prospects of the company. Spreading rumours is another common strategy for pumping up a share price. A select group of speculative investors buys into a company at penny prices and then the massive pump campaign begins.
Investors find their email inboxes crammed with information on the latest hot prospect, coming from multiple sources, all of them seemingly credible. So they begin buying. There are better sources to look for penny stock prospects.
However, if you want to avoid getting burned you need to do your homework, perhaps even more so than with the shares of larger companies. Penny stocks always have a story to tell, and there are specific things you can do to help determine whether the story is little more than a fairy tale. First, thoroughly investigate the experience of company management. Some of these penny stocks are run by people who have had experience in larger companies in the same industry. Who are the experts they employ and what have they done?
Third, investigate the experience of the members of the Board. Look for people with entrepreneurial experience as well as experience with companies who have yet to turn a profit. Fourth, you need to know where the cash is coming from and how fast the company is spending it.
Companies with a high burn rate can run out of money to continue operating even when prospects are improving. You also need to know whether another company is exploring in the same geographic area. Finally, price targets with penny stocks are even more important than with larger companies. The rapid fall of these shares if the story behind them goes bad can be mercilessly quick.
Please note that TheBull. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull. You should seek professional advice before making any investment decisions.
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