Penny stocks jingling anew in bear market

Though the high-risk stigma associated with penny stocks keeps many investors away, analysts say this may be the best time to buy, as many companies are poised to show gains.

Dawn Kawamoto Former Staff writer, CNET News
Dawn Kawamoto covered enterprise security and financial news relating to technology for CNET News.
Dawn Kawamoto
4 min read
Penny stocks are looking to shine.

As the markets tanked and investors fled the Internet sector, a number of companies--even big brand names--found that their double-digit stocks were suddenly worth pennies. These victims of a sector sell-off, some of which have the brand recognition and the cash on hand to see them through profitability, have quickly become market refugees.

"This is the best time to buy penny stocks," said George Schlieben, founder of penny-stock online newsletter Global Penny Stocks. "You have some well-known tech names that have fallen out of favor but still have a good story and continue to be listed and have analyst coverage."

The stigma associated with penny stocks keeps many individual investors away--high risk, illiquidity, and no interest from institutional investors that buy and sell large blocks of stock. But at what point do penny stocks make a great buy?

"People love to take a chance. And the higher the risk, the more excitement," Schlieben said. "There is a perception, and in a lot of cases it's justified, that penny stocks can have a higher and quicker percentage gain than a mid- to large-cap stock."

So while a 70 percent gain on a penny stock and a 70 percent gain on a $20 stock will yield the same windfall on a $5,000 investment, Schlieben said penny-stock investors may get there quicker.

The stock of online grocer Peapod, for example, has nearly doubled since the start of the year. The stock traded as low as 68 cents in January and closed unchanged Wednesday at $1.31. The company announced plans earlier this month to close its San Francisco operations as part of a cost-cutting measure. And last month, Peapod said its parent company, Royal Ahold, increased its line of credit to $50 million from $20 million--providing a leg up in Peapod's efforts to reach profitability in some of its markets by summer.

But at the same time, blue-chip companies from Microsoft to Intel have yet to pull off a similar feat in this bear market.

Other stocks that have emerged as winners from penny-stock status include online florist FTD.com and online insurance company InsWeb.

FTD.com has posted two consecutive quarters of profits and said it expects to remain profitable for the remainder of the year, despite a slowing economy. The stock, which has traded as low as $1.06 during the past 12 months, closed Wednesday at $2.72.

InsWeb, which had a 52-week low of 50 cents, closed Wednesday at $1.38--in part driven by narrower losses in the fourth quarter and expectations of breaking even in the third quarter.

Pay attention to detail
Analysts say some deals may be found among the copper heap, providing investors take a close look at several key areas.

"In a bear market, it's paramount to know how much cash they have to weather the storm," Schlieben said. "And if the stock has been oversold, then it may be a good buy. Most stocks on the Nasdaq have been dumped not because they have bad problems, but more because people got scared holding the stocks."

He added that 95 percent of penny-stock investors tend to be buy-and-hold players, in contrast to day traders, who frequented these stocks in the markets' boom days.

Scott Appleby, an analyst with Robertson Stephens, recommends that a company have twice the amount of cash needed to reach profitability. That extra cushion is something investors may seek in a penny stock, given the higher level of risk that comes with such a low-trading stock, he said.

"Cash is vital. But even if a penny-stock company is able to reach profitability with the cash they have, it may still be difficult for them to attract investors," Appleby said. "At least having enough cash gives them a fighting chance."

Peter Rogers, director of research at WR Hambrecht, said a company needs not only enough cash but also a good management team to execute on getting well-positioned in the marketplace.

Analysts caution that there are a number of downsides to investing in a penny stock, no matter what level of cash it has in its reserves.

A penny stock that trades below what it is worth based on its cash alone will likely never regain momentum, analysts say.

"Once a company has been characterized as a penny stock, it's in a whole different game," said Satya Pradhuman, Merrill Lynch's small-cap research director. "The stock is very illiquid, and it's difficult to attract investors."

Not quite enough
Institutional investors, such as mutual fund portfolio managers, tend to buy large blocks of stocks to build a position in a company. But often, small, micro and penny stocks do not have enough market capitalization or liquidity to attract institutional investors.

Nonetheless, Schlieben noted that individual investors can take large positions in penny-stock companies with relatively little money.

"There's not a great deal of places you can go with $5,000 to $10,000 and take a sizable position in a company," he said, adding, "We advise people to spread their investments over four or five stocks, since about 30 percent of their investments will go up in smoke."