What are penny stocks and how to invest in them

Penny stocks don’t have the best reputation. 

They may be cheap but they’re often volatile, which makes it especially hard to predict what their price is going to do. 

It doesn’t help that many of the penny shares UK investors buy are often treated like racehorses at a bookies’ office. 

But, as tends to be the case with stereotypes, the idea that all penny stocks and shares are for speculative punts or Wolf of Wall Street scammers isn’t true. There are still penny stocks to buy that can offer good value for an investor.

Key to that is avoiding getting sucked into what looks like a deal but is actually just a dud hiding behind a cheap price. In this guide, we’ll run through how to identify good value when investing in penny stocks so you can decide whether these stocks are right for you or not.

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Don't expect to get rich quick.

It’s important to remember that price does not equate to value. Just because one share is cheaper than others doesn’t mean it has a better opportunity for growth. 

A meal deal is great and all, but if the chicken salad’s gone off, it won’t make for a great lunch.

Likewise, with penny stocks, you might be getting what you paid for: nothing all too good.

Penny stocks are not a get rich quick scheme. And if anything, they require an extra layer of scrutiny before you invest in them rather than other shares. That’s because penny shares tend to represent small companies that have fewer regulations and reporting requirements. So they’re not as closely monitored as other, larger firms.

Before we get stuck into all things penny-wise, it’s important to highlight that this is not a suggestion or recommendation that you buy or sell any of the penny stocks mentioned. 

Remember that everyone has their own goals and unique financial circumstances. These, along with your tolerance for investment risk and time horizon, should inform the mix of assets in your portfolio. 

Our resource hub for investing in the stock market might be able to help make that blend a bit clearer for you and our guide on how to invest in stocks is a great start for first-time investors. And if you are still unsure of how to pick investments, speak to a qualified financial advisor. 

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What are penny stocks?

Let’s start with the basics: what is a penny stock or penny share?

It’s not exactly what it says on the tin. Contrary to their name, a penny stock won’t always cost just a penny. 

A share is usually classified as a penny stock if it costs less than £1 in the UK or $5 in the US.

These companies tend to have market caps below £100m in the UK or $300m in the US. So smaller, lesser known companies are sometimes dubbed penny stocks even if their share price is above £1 or $5. There are thousands of firms listed on exchanges across the world and many of them fulfil this definition.

And while the most commonly bought stocks on Freetrade tend to be larger companies, smaller companies can be hidden gems if you know where to look and what to look for. Size isn’t everything. At the same time, they’re significantly more volatile and tend to carry a lot more risk.

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Where are penny shares traded?

‍You can buy penny stocks on most stock exchanges but the most popular shares tend to trade on UK and US exchanges.

LSE penny stocks

‍In the UK, penny stocks are usually found on the AIM (Alternative Investment Market) index. AIM is a sub-market of the (LSE) London Stock Exchange with fewer regulatory and listing requirements. That enables smaller firms to access capital with greater ease than if they were to try and list on the LSE Main Market.

The Main Market requires the following of any company looking to float:

1. Must have existed for at least three years 
2. Must have a market cap of at least £700,000
3. Must have enough working capital for at least one year’s trading
4. Must be willing to float at least 25% of its share capital

AIM, on the other hand, doesn’t have any of these requirements. That makes AIM-listed companies less regulated and higher risk than Main Market-listed companies. At the same time, AIM companies are more likely to be in growth mode than those found on the Main Market. So your risk tolerance and investment objectives are key to determining whether AIM penny stocks make sense for your portfolio and financial circumstances.

One of the benefits of investing in AIM-listed shares is that you won’t pay stamp duty, so long as those shares aren’t listed on another market too. On the Main Market, you’ll pay a 0.5% stamp duty tax on the value of your stock purchase (but not the stock’s sale).

AIM’s less regulated nature is why it’s especially important to understand the companies behind the investment when it comes to penny stocks. You may need to do extra digging than you would with a Main Market listed stock, given they’re likely to have less readily available investor information. AIM has a bit of a reputation for being the wild west. While there are some big winners on the exchange, there are no doubt some duds too.

Source: FE, as at 31 May 2022. Basis: bid-bid in local currency terms with income reinvested.

Comparing the performance of the UK’s largest 100 Main Market companies to the entire UK AIM index, AIM has significantly underperformed every year over the past five years. 

Historically, AIM has performed better when inflation expectations rise and the price of commodities do too. This period is known as ‘a cyclical upturn’, where the market’s appetite for risk tends to increase. Given AIM shares are higher risk than those on the UK’s Main Market, AIM tends to be in higher demand.

The entire AIM index comprises a large breadth of companies, totalling 852 firms as of January 2022. This goes to show a diverse portfolio of stocks won’t guarantee you better returns if those stocks are exhibiting erratic performance, as the younger firms do their best ot find their footing. In some years, the largest 100 AIM stocks have performed even worse than the entire AIM index.

OTC penny stocks vs NYSE/NASDAQ penny stocks

In the US, you can find penny stocks on the Nasdaq and the NYSE (New York Stock Exchange). But because penny stocks tend to have lower trading volumes, some stock brokers won’t offer all of the listed options.

Another way of accessing penny stocks is through the over the counter (OTC) market. These stocks are known as pink sheet listings. Many pink sheet listings are seen as more speculative, volatile and carry higher risk than those on a major stock exchange. 

OTC stocks are purchased directly from a broker or other financial services business. This essentially means there’s no intermediary between you and the stock owner, so the transaction carries a higher level of risk.

The main reason a penny share would trade OTC as opposed to on the Nasdaq or NYSE is that it won’t have to adhere to the stricter regulatory standards of the other stock exchanges. It’s similar to why a UK share would list on AIM as opposed to the Main Market.

This can be a matter of a small company preferring not to undergo the costly regulatory burden of fulfilling the trading. It might also mean the company is simply incapable of meeting those same requirements. 

The latter reasoning might be a red flag, but unfortunately, there’s no real way of knowing why a company chose to list OTC as opposed to on a major exchange. Yet again, giving us investors added reason to do our research before jumping into a new investment, no matter how small that price tag may seem.

Pros of investing in penny stocks‍

Here’s a recap of some potential advantages of investing in a penny stock:

• When taking on higher risk with penny stocks, you might get a greater gain. After all, as an investor, you’d only be willing to accept a heightened level of risk if you had hopes of achieving a similarly greater level of share growth.
• Penny stocks tend to be investments in smaller companies. Size isn’t everything, but these firms are usually younger and more nimble, which means they could experience more explosive growth and at a faster rate than older companies would.
• Penny shares are cheaper than some of the larger cap, more popular shares. So they might be more accessible to investors who find the share prices of other investments are higher than what they’d like to spend.

Cons of investing in penny stocks

And here are some of the disadvantages of trading penny stocks:

• While a penny stock might be cheaper than many other shares on the market, cheap doesn’t mean good value (are we sounding like a broken record yet?). There are also other ways of accessing shares at a cheaper price, such as fractional shares if a company’s entire share seems out of reach.
• Higher risk doesn’t always equal higher gain, and often it can lead to a greater loss. 
• Penny shares usually have low liquidity, which means fewer investors are willing to buy and sell these shares. So penny stocks may have poorer pricing and wider spreads than more expensive stocks. The spread looks at the price a buyer is willing to pay for a stock compared to the price a seller would take for the stock. A wider spread means you may be taking on more risk because it could be harder to get the price you’re hoping to buy or sell the stock at. And if that’s the case, you’ll need to make a high enough return to cover that spread just to break even.

How to invest in penny stocks?

Before you consider investing in penny stocks, you need to decide whether the high volatility and risk attached are suitable for you and your investment needs. You’ll need to be comfortable with the greater likelihood that the value of your investment could go down. 

If you’re financially able to, and have the risk tolerance to take on the heightened level of uncertainty, then perhaps some penny shares may be a fit for your portfolio. But even if that is the case, your best bet isn’t to just set out searching for penny stocks. If you find an investment that you think is fairly priced and offers good value, and it happens to be a penny stock, then that’s a better direction to take. 

Once you do, you can trade penny shares in the same way as you’d trade more expensive shares. 

1. Research to find the right stocks for you. As we’ve mentioned, this stage is key to deciding whether a penny stock is right for your portfolio. You might choose to investigate emerging high growth sectors, check out bourgeoning trends in the market, or read other stock news and analysis for ideas about rising industries. 
2. If you find a penny stock that you believe suits your investment objective, you can buy penny shares online in the UK. It’s as simple as searching for the stock on your respective brokerage platform. Freetrade has over 6,000 stocks to choose from in app, with many priced at under £1 or $5.
3. Decide how much you want to buy. If you’ve found a penny stock you’d like to buy, you’ll then need to figure out the size of the trade you’d like to make. Remember, just because one share is cheap doesn’t mean you need to buy more. There’s no harm in starting small and gradually adding more to your investment as you gain confidence in its performance relative to the market.
4. Place your trade. Once you’ve made your trade with your broker of choice, it’s good to monitor your investment. That’s especially important for volatile, less liquid stocks which may fluctuate with greater speed and intensity than larger, more liquid stocks. You might choose to create a stop-loss order, setting a price at which your shares will automatically sell to limit your losses. 

List of most traded penny stocks on Freetrade 

To reiterate, the following list of penny stocks is not a recommendation to buy or sell any of these securities, nor is it a list of penny stocks to watch. This is simply a wrap-up of some of the most popular penny stocks purchased on Freetrade in 2021. 

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Penny stocks UK list

Source: 10 most popular UK penny stocks, bought for £1 or less in 2021 on Freetrade. 

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Penny stocks US list

Source: 10 most popular US penny stocks, bought for $5 (aprx. £4) or less in 2021 on Freetrade. 

You may notice there isn’t much by way of similarities among the most bought US and UK penny shares. Though several cannabis companies have made the cut on both lists, as have a few blockchain firms.

The first publicly traded blockchain firm listed on the LSE in 2019, and only in 2021 did the first publicly traded cannabis company gain a listing. Both fields are still quite nascent. And although something shiny and new can be exciting, it can also be a lot of overhype.

That’s why it’s so important to see through the noise when it comes to penny stocks. While many investors hoped cannabis stocks would be a lucrative way of capitalising on potential legislative changes like legalisation, that really hasn’t been the case yet. 

And although plenty of cryptocurrencies got a boost in 2021, 2022 has seen even the biggest ones succumb to a sell-off. As demand for cryptocurrency falls and more states consider bans on crypto mining, blockchain firms will feel the heat too.

How to find penny stocks

If you’re trying to find a penny stock for the sake of it being a penny stock, stop.

Prioritising the price of a stock above everything else will lead to mistakes in decision making because price alone means nothing in isolation. And ultimately, making decisions without sufficient data leads to taking on much higher risk than needed.

On the flip side, if the reason you’re keen on penny stocks is for the potential of a higher return from a more volatile share, that’s not always going to be the case.

Consider Lloyds Bank, which has long traded at less than a pound, and was the most popular share bought under £1 on Freetrade last year. Though with a market cap of £31.6bn, it wouldn’t be dubbed a penny stock by most investors. It’s a 256-year-old bank with a proven ability to generate a profit.

But its share price never really recovered after the 2008 financial crisis, nor has the bank managed to get back to its pre-pandemic levels.

That’s why it’s important to look at the company first, then determine whether the price of the stock lines up with the value you think that investment can bring. 

4 Penny stocks investment tips for beginners

1. Look for growth sectors, then work your way backwards. An older industry isn’t necessarily a bad one, but usually, it’ll already have clear, well-established dominant players which are less prone to explosive growth. 

So if you want higher risk stocks with larger growth potential, look at the industries you believe are primed to take off. The metaverse has gone from a buzzword to an investable segment of the market. Green energy is another budding area with plenty of new firms and ETFs entering the space at breakneck speed.

2. Find out who’s driving the ship and figure out what the management team at the helm is like. Do they have a proven track record of managing other small companies? 

You always want to trust the management team of companies you invest in, but especially so with penny stocks. In smaller companies, management tends to have more power and less oversight than in Main Market listed companies. So you need to feel confident that even without the added red tape of a Main Market listing, the company is still in good hands.

3. Focus on fundamentals. Tempting as it may be to believe a penny stock will yield a higher return than a more expensive share, it’s certainly not always the case. 

It’s only a sound investment if the underlying business is sound too. For penny stocks, there are some metrics in particular which could help you determine the additional risk of investing in smaller cap companies.

• Liquidity ratios: these are particularly important for penny stocks as they measure a company’s ability to cover short-term liabilities. Typically, smaller companies have less cash on hand or higher levels of debt, for instance, because they’re more focussed on financing growth as opposed to paying dividends. A lower liquidity ratio might mean the company’s having a hard time advancing its operations, because it has less cash than debts, for instance. 

• One example of a liquidity ratio is the current ratio. It’s measured by taking a company’s current assets and dividing these by current liabilities. Typically, a value of 0.5 or below would indicate low liquidity. And as an investor, you need to be wary that a company with lower liquidity would be at higher risk of defaulting on its payments to suppliers, and potentially you as an investor.

• Valuation ratios: these ratios can help you figure out if a stock is a good investment at its current price. The price to earnings (or P/E ratio) is an example of a popular valuation measure used to assess a stock’s price relative to its earnings per share (EPS). P/E is calculated by dividing the stock price by EPS. When you’re using this ratio, it’s a relative exercise, meaning it’s about what you get for the price you pay. So a low P/E ratio might mean the stock’s price is low, but that’s relative to the firm’s earnings. When it comes to penny stocks, the P/E ratio is especially important because it considers the stock's cheapness relative to what the company is proving about its worth.

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4. Don’t be fooled by share price alone. We’ve said it once (okay, maybe a couple of times more than that) but we’ll say it again. Penny shares are no exception to the rule you should always question the investment case being presented to you. Sometimes, if it’s too good to be true, it is. 

Stocks under $1 with potential

A look at the performance of some of the most popular UK penny shares shows that stocks at lower price points can witness massive fluctuations in their share prices. That’s a matter of simple maths. After all, if you’re starting at a lower basepoint, any change will seem greater than if you begin somewhere higher.

Source: FE, as at 5 June 2022. Basis: bid-bid in local currency terms with income reinvested.

The above selection is just a snippet of some of the most popular UK penny stocks on Freetrade. And it proves just how much those returns can ebb and flow. A stock might look like it has ‘potential’ one year, but that can turn around just as quick in another. 

Sometimes, smaller or newer companies can be subject to a lot of hype, which means their returns are especially challenging to predict. Because an inflated share price may be the result of ever-excited market sentiment as opposed to consistent profitability or reliable dividend payments. As we’ve mentioned, that’s another reason penny stocks are worth an extra dose of monitoring, or measures like stop losses to prevent huge declines in your portfolio’s value.

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Can you get rich from investing in penny stocks?

Ah, if only it were that easy.

The assumption that a cheap stock can make you rich quick is unfortunately by and large not true. More often than not, the reason a stock costs less than £1 is because it’s worth less than £1.

While we might be sounding like penny share party poopers at this point, it’s not to say a penny share is never right for your portfolio.

If you’ve done your research and feel comfortable with the level of risk involved in your investment, then a penny stock might make sense for you. And given their lower price point, the growth potential is higher. So theoretically, you could make a good return on penny stocks. But investing based on price alone is never a sound investment decision.

These stocks need to be treated with some extra scrutiny than a Main Market or large stock exchange investment. That’s especially important during times of high market volatility, where even mega cap companies are witnessing large changes in share prices.

Those firms are much more used to weathering bear markets than are new firms to list. And while their returns may be more gradual with slower growth than that of a penny share, more often than not, slow and steady wins the race.

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