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The Return of Penny Stock Speculation
February 21st, 2008
Penny stocks are a creature all their own. While they trade just like their higher priced brothers and sisters, they really do respond differently to the market's under-currents.
What you've seen in the overall markets in the last six months has been a massive increase in anxiety, confusion, and volatility. This has affected blue-chip names like IBM and Microsoft, and no publicly traded stock has been immune to the resulting negative bias.
It's a refrain you've most likely heard dozens of times in the last few months, between the high energy prices, sub-prime lending mess, and possible recession, stocks of all kinds have been subject to a wild ride.
The response to this investment 'commotion' is predictable and has played out the same way many times in the past. Specifically, investors of all types and sizes, including multi-billion dollar institutional traders, start pulling money out of equities. This depresses prices, increases the supply of the shares, reduces demand, and usually exacerbates the general investing fear that caused the problems in the first place.
At the same time, the majority of the money gets re-invested in safer, volatility proof, recession proof vehicles, such as the companies involved in commodities and the commodities themselves (gold, coal, oil, etc...). Until recent history, the US dollar would also see much of that 'flight to quality.'
Now, the problem for penny stock traders comes to light. A flight to quality comes hand in hand with a flight away from speculation. A major percentage of the trading price of most penny stocks is made up of speculation. Thus, a major percentage of the trading price of most penny stocks is at risk.
Anyone following a basket of penny stocks over the last six months would find the same result almost across the board. Prices have been trending down. The only exceptions would be some of the resource stocks that benefit from higher commodity prices, but most sub $5.00 stocks, from just about any industry, have seen a notable drop-off in share prices.
Many quality penny stocks have the potential to trade dramatically higher. Yet, as investors turn away from speculation, and instead focus just on surviving the (take your pick) recession / economic slowdown / high oil prices / weak dollar / sinking housing prices... they forget about speculating on the future, and start focusing on the 'now.'
Many penny stock traders ask, "Why invest in the future potential of this tiny little company, when even the biggest companies are coming apart at the seams?"
The result - the speculative premium put on most penny stocks decreases. What used to be a $2 stock, with the potential of becoming worth $5, becomes a $1 stock, with the potential still to be worth $5.
With a return of strength to this speculative premium, which is truly the lifeblood of penny stocks, you can see this same stock in our example above trading at $3 or $5 or even higher.
This is not unlike the 'risk premium' put on oil, which is the difference in oil prices between what the fundamentals of supply and production dictate, and what political and military influences add to the final cost.
Now, the most important thing about speculative premium is that it should be treated as a contrarian indicator. The best time to buy is when the impact of speculation is at its lowest (like now for example). The best time to sell is when it is at its highest (like in the dot-com bubble just before it burst).
Unfortunately, most investors act quite the opposite way. Looking at any basket of penny stocks (our own Hot List picks being no exception), the last six months should scare you away. However, when you are looking at fundamentally strong, well-managed companies, as we do with our Hot List picks, this becomes a great entry opportunity.
Investors could really benefit by getting involved with penny stocks when they are devoid of speculation. Most of these stocks will return to glory as their business plans play out, independent of the level of speculative premium infused into the shares. Then, add a return to speculation when the overall markets settle down, and you should see many penny stocks track higher in response.
Speculation will return to penny stocks, as it always has over the course of the last hundred years. The best time to invest in penny stocks is when they no or only a minimal speculative premium.
In other words, do like Warren Buffet suggests (a useful reference for penny stock investors, even though his shares of Berkshire Hathaway trade at $4,701.00 each): buy what no one else wants, then sell it back to them when they want it.
Right now no one wants penny stocks. 'Right now' will not last forever.