It’s amazing how many novice traders are lured to the so called penny dreadful stocks - that is shares with a price of only a few cents. The reason is of course greed; penny dreadful stocks have the potential to experience astronomical capital appreciation. What most people fail to consider is that for every stock that goes to the moon, there are many more that don’t.
The penny dreadful is usually extremely speculative in nature, with high levels of debt, little to no positive cash flow and nothing more than the promise of big things to come. It is actually surprising just how many penny dreadful stocks there are on offer. Currently there are almost 2000 listed and active shares on the ASX, and only one in five has a share price over one dollar. In fact, around 43% are trading at less than ten cents per share and over a quarter of all listed stocks are worth less than five cents per share.
The real appeal with these stocks lies in the fact that there have been some amazing success stories in the past, and there are certainly some great examples. Consider Fortescue Metals - five years ago it was trading at just 7c, and at its height last year it made it to $13.15. If you had invested just $10,000 in Fortescue at the start of 2004, you would have seen your investment grow to over $1.87 million in less than five years!
The trouble with these kinds of examples is that they assume you actually sell out at the best possible time. The reality of course is that very few shareholders would have experienced this gain, with most selling out well before the high was reached. Of course, the shorter term volatility of such stocks means that many traders would have actually made losses along the way as the share price experienced temporary pull backs.
But the main thing to remember is that although many penny dreadfuls have this potential, the majority will never achieve this type of growth. For example, of all the stocks that were trading at less than 10c back in 2004, around 15% no longer exist. Of those that are still trading today, less than a fifth are worth more than 10 cents today, and only 3% are worth more than $1. Furthermore, those that are trading at more than 10 cents today, around half took more than two years to go above this mark. That is, to have made any real profit you would have had to sit on an underperforming stock for more than two years. In reality, few traders would have the patience to sit on an underperforming stock for that long.
Another thing to consider is that penny dreadfuls do not pay a dividend, which is no surprise given that most are yet to make a profit. As I have discussed in previous articles, dividends really can make all the difference – especially if they are reinvested. To understand this, you need only compare the ASX200 with ASX200 accumulation index (an index that factors in the reinvestment of dividends). Because of the massive correction we have seen over the past 14 months, the ASX 200 has gained only 13% since early 2004. The ASX200 accumulation index however is up 40.5% over the same period. Dividends make a LOT of difference, and that’s just another reason why penny dreadfuls are worth avoiding.
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Another difficulty you find with the penny dreadful is that they are often extremely illiquid. That means that there are often so few buy or sell orders in the market, it can be difficult to enter or exit a position at a price that is suitable, and often there will be insufficient volume.
If you want to speculate on these kinds of stocks, it’s your choice. But if you are basing your investment decision on nothing more than rumour and hope, and know very little about the actual business fundamentals, chances are you will lose most of your money.
If on the other hand you are looking to invest sensibly and safely, it’s best to stick to the larger, well established businesses. Sure they are unlikely to make you an instant millionaire overnight, but what they will offer is reliable and growing income returns through dividends, and the best long term capital returns available. If you would like to learn more, please visit www.dividendkey.com.
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