Penny shares may look attractive as a source of big profits from small price movements but the pros and cons suggest investment potential may be limited.
Penny shares are usually cheap for a reason and many had strong prices in the past but the companies profit and standing has often declined taking the stock price with it.
What is a Penny Share?
The example here is probably more robust than many penny shares. At one time Parity was a substantial and well regarded IT services company. During 2007-2010 its price fell from a peak of around 90 pence to below 9 pence, even in early summer 2011 it is still only 24 pence. It has therefore been well into the penny share range for some time. There is no standard definition of penny shares but they are usually based on arbitrary upper limits say £0.50 to around £2-3 which would include many FTSE 100 companies such as Vodafone. So a limit on market capitalisation is usually also included in the criteria.
Low Price is Not an Indicator of Good Value
Many of the best companies have very high share prices. In the USA blue-chip stocks such as Google, Apple or Coca-Cola have prices between $55 and $600; in the UK the shares tend to be divided into smaller denominations so the prices tend to be somewhat lower. For a long time, Berkshire-Hathaway, the US investment company run by Warren Buffett, had a very large share which reached more than $120,000. As those examples show a high price can still be good value as an investment.
Conversely a low price of itself does not automatically make the shares good value. It may simply be due to the company’s equity being split into a large number of low value shares as with Parity. Or even worse it may be a company in terminal decline with a real risk of the investor’s funds being lost.
Buying and Selling Penny Shares –the Bid to Offer Spread
Parity has a bid price, the price to buy shares, of 9.5 pence and the selling price, the offer or ask price, is 8.5 pence. Even without considering transactions costs to make a profit requires a rise of more than a penny which does not seem much. Indeed on most mainstream shares it would be within the normal hour to hour price variation. By comparison the FTSE 100 share National Grid has a bid-offer spread of half a penny on share price of £6.50 – effectively 145 times smaller in percentage terms.
However for a penny share such as Parity one penny would be a movement of nearly 12% on the offer price – the sort of price movement that is equivalent to the FTSE 100 rising from 5,500 to over 6,000 or the Dow Jones Industrial Average moving from 11,000 to over 13,500. That movement would just be enough to breakeven so to match the market as a whole a penny share would need to rise by twice that in a year.
Ove the long term the major stock markets rise around 10-12% over an average year in a steady bull, or rising, market. Hence wise investors include an index tracking component in their portfolio.
Liquidity, Trading Volumes and Price Sensitivity
However to compound the problem for penny shares is their lack of liquidity in that transaction volumes tend to be low and as a result selling quite modest share holding can drive the price down.
For example for Parity the maximum online transaction volume is 100,000 or about £10,000, above that the online stockbroker has to go to the market for a price as there may not be a buyer for that many shares. That transaction would represents about a third of a typical days trading volume for Parity of 325,000.
Positive Reasons to Buy Penny Shares are Difficult to Find
It is difficult to argue for any positive reasons for an investor to buy penny shares. However there are three groups that may choose to buy them.
Gamblers may like them but even then the need for large percentage price movements should make them think twice about whether the risk is worthwhile. Even gamblers buying penny shares should do so with money they can afford to lose; don’t bet the housekeeping! So even for traders penny shares are of doubtful merit.
Perhaps there may be a case for some investors buying into a penny share of a new company that is establishing itself in the marketplace . These are high risk investments as most start-ups fail to justify initial promise. But investors with substantial portfolios might wish to take a gamble on such a start up hoping they have found the next Google or Amazon. The investor should be able to afford to lose their stake.
The safest way of investing in penny shares is with inside knowledge that will make investment risk lower. However insider dealing is illegal and with the low transaction volumes any unusual activity will be highly visible. It might eliminate the investment risk but brings in the risk of prison time instead of merely losing money. Fortunately that makes it unacceptable for most people.
Is There a Place for Penny Shares in Balanced Investment Portfolio?
Generally there is then no real case for including penny shares in a long term investment portfolio. There are safer and better performing investments that pay good dividends and achieve capital growth.
Penny shares therefore are not really suitable for most people, most of whom will need a low risk investment portfolio to provide financial security in retirement.
First appeared on Suite101