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The myth has been old and strong – Microsoft Corporation (MSFT - Analyst Report) and Wal-Mart Stores Inc. (WMT - Analyst Report) were once penny stocks. Jordan Belfort (at least as seen in Martin Scorsese’s movie The Wolf of Wall Street) utters the same myth in order to sell the penny stocks. Jordan Belfort had also said: “As long as it gets done, it doesn’t matter how.” With that belief many traders might trick investors to buy or splurge money on penny stocks, but that might peter out the entire investment.

Before we discuss why investors should stay away from the risky penny stocks, let us take a look at the theory and practice.

What Are Penny Stocks?

According to Investopedia, penny stocks trade at a relatively low price and market capitalization, usually outside of the major market exchanges. These are highly speculative shares being offered by very small companies that hardly have any track record. Generally market capitalization of a penny stock is between $50 and $300 million. Most importantly, low liquidity is a key catachrestic of these stocks.

The Securities & Exchange Commission (SEC) classifies stocks under $5 to be a penny stock. Some also consider $3 to be the benchmark, while many consider stocks lesser than $1 to be a penny stock.

Were Microsoft and Walmart Penny Stocks Ever?

These two stocks were never penny stocks! What has confused investors is their ‘split-adjusted’ price.

Following stock splits, there were adjustments made to these stocks’ historic price to show the effect. Accordingly, the historic price on paper dropped below a dollar, but that never means the stock ever traded at that level.

The tech behemoth Microsoft had closed at $28 a piece on its debut on Nasdaq on Mar 13, 1986. In fact, the historic low for Microsoft is around $15. Considering the stock splits for Microsoft so far, the price on the debut day would drop way below $1.

The same logic of stock splits applies to Walmart, which had its initial public offering in 1970 at a price of $16.50. The stock was unlisted on major benchmarks for a couple of years and traded "over the counter." It got listed on the New York Stock Exchange in 1972.

Wolves May Bite

Jordan Belfort is known to many for his rags to riches headline story and for being convicted for manipulation of the stock market. Now a motivational speaker, he ran a ‘penny stock boiler room’ and earned millions by selling investors the "penny stocks."

The U.S. Securities and Exchange Commission or related legal bodies have often send subpoenas to broking houses for selling or often compelling investors to buy these dubious micro-cap stocks. If the regulatory bodies have often jumped into action to safeguard investors, there obviously is something wrong with these stocks or the act of trading.

The Pink Sheet or OTCBB stocks are not required to match the minimum standard requirements to be listed on exchanges. Moreover, Pink Sheet stocks are not liable to file documents with SEC and thus investors hardly have any timely information about the company.

Going Home with Profit – Your Choice

Jordan Belfort said this too: “Success isn’t only about what you do. Its also about what you don’t.”

Like Belfort or his company Stratton Oakmont, there were and are other businessmen who had mastered the skill of selling penny stocks. For example, Robert Emmet Brennan ran the infamous First Jersey Securities. We have also seen the U.S. SEC filing charges against Park Financial Group following investigations of its role in running pump and dump scheme in 2002-03.

So be careful to stay away from the pink sheet or fall prey to the ‘pump and dump’ strategy. There have been tales of people becoming super rich by investing in penny stocks, but there are a larger number of stories where investors’ wealth has been “pumped and dumped.” Thus, it is a safer bet to invest in securities with a proven history, a large market capitalization, high liquidity and one that conforms to the listing norms.

When $1 Turned Big

Interestingly, we have had examples of major companies that traded below $1 at a time and have now jumped manifold. However, it was just their price dropping to or below a dollar and nothing else qualified them as the micro-cap or the dubious penny stocks.

These included the likes of:

Citigroup Inc. (C - Analyst Report): The financial behemoth’s share price had hit an intra-day low of 97 cents on Mar 5, 2009 before closing at $1.02. On Mar 3, 2009, the stock had a Zacks Rank #3 (Hold). The slump in share price was a beating the stock got during the financial crisis and in no way can one call Citigroup a penny stock. The company currently has a market capitalization of about $150 billion and is trading at $48 a piece.

Office Depot, Inc. (ODP - Analyst Report): The specialty retailer saw its shares dropping to 59 cents on Mar 9, 2009; another recession victim. In Feb 2009, the stock had a Zacks Rank #4 (Sell), which was upgraded to a Zacks Rank #2 (Buy) on Apr 30, 2009.  With market capitalizations of $1.5 billion, this office products and services supplier is currently trading at over $5.

American Axle & Manufacturing Holdings Inc. (AXL - Analyst Report): This leading supplier of driveline systems, modules and components for the light vehicle market took a severe hit when automakers General Motors Co. (GM - Analyst Report) and Chrysler got bankrupted. On Mar 9, 2009, the shares had closed at 29 cents. While on Feb 7, 2009, the stocks had a Zacks Rank #3 (Hold), on Mar 25, 2009 it got upgraded to a Zacks Rank #2 (Buy). The company currently has a market capitalization of $1.45 billion and is now trading over $19.

Want to ‘Start Small, End Big’?

If you are interested in buying stocks that technically are not penny stocks but are trading below $1, here are two options:

These two stocks sport favorable Zacks Rank, have market capitalization of at least $1 billion and are also seeing positive earnings estimate revision of late.

TransAtlantic Petroleum Ltd. (TAT - Snapshot Report): This international energy company owns interests in 3.9 million net onshore acres of developed and undeveloped oil and natural gas.  The latest operational update provided by the company noted it has three active rigs in southeastern Turkey, one active rig in the Thrace Basin in northwestern Turkey and one active rig in Bulgaria. It expects to drill about 33 to 49 wells in 2014.

It currently carries a Zacks Rank #2 (Buy) and has market capitalization of $291.28 million. The stock is current trading at 78 cents (as of Feb 20).

TransAtlantic is expected to announce its fourth quarter 2013 earnings result in mid-March.

Lake Shore Gold Corp. (LSG): This gold miner acquires, explores and develops gold properties in Canada. In January the company reported that the preliminary 2013 operating cost per ounce sold beat its guidance. Company president and CEO also said: “We have completed a very successful year in 2013, including four consecutive quarters of cost improvements, four consecutive quarters of improved grades, increased mill throughput volumes that were 60% higher at year end than when the year began and record production of 134,600 ounces of gold (previously announced on January 7, 2014), which achieved the top end of our guidance for the year.”

It currently carries a Zacks Rank #2 (Buy) and has a market capitalization of $344.96 million. The stock is trading at 83 cents (as of Feb 20).

To Conclude

Former Stratton Oakmont executive Andrew Greene has recently sued Paramount Pictures and other producers for his portrayal in Oscar nominated movie Wolf of Wall Street. Greene says the manner in which he has been depicted in the motion picture has distressed him. Similarly, the truth about the value of penny stocks is only relative, a partial truth at best.

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