FOOL SCHOOL
Beware Of Penny Shares

February 25, 2002

Many people's first taste of investing in the stock market may well be a tip to pick up some penny shares. As the name suggests these are shares whose price is just a handful of pence rather several pounds.

Many people mistakenly believe that because these shares come in small denominations they are somehow cheaper than those that are nominally larger, and therefore better value. This is far from the case. For example, take two well-known companies in the FTSE 100 index. Mobile phone operator Vodafone (LSE: VOD) has a share price of around 125p at the time of writing. Shares in Barclays Bank (LSE: BARC) currently stand at £21, over sixteen times as high. However Vodafone is valued at £87b whereas Barclays is worth £34b.

So Barclays is less than half the size of Vodafone despite having a nominal share price many times greater. All the share price indicates is how many shares each company has issued. There are 68b Vodafone shares floating around out there, but only 1.66b Barclays shares, less than 3% of the number of Vodafone shares.

Currently, no FTSE 100 companies have share prices under 50p. Indeed penny share companies tend to be very small, worth less than £50m. The shares of many speculative mining companies tend to be quoted in prices of a few pennies. So do struggling ventures and fallen angels in other sectors.

Another misconception is that because the price is already so low it cannot fall much further and has more potential to go higher. In fact the reverse is true. Any share price can fall to zero, and lose you 100% of your money. Penny shares are far more likely to do this because they are smaller businesses and tend to be in riskier sectors. And the fact that the share price is low does not give more potential to rise. It is the prospects of the company itself that determine this.

The cost of dealing in penny shares is also a lot higher. This is because the difference between the bid and offer prices, the price at which either you sell or buy the shares is much larger in percentage terms than it is for big companies.

Take popular games software company Rage Software (LSE: RGE). At the time of writing, brokers are selling this share for 5.25p and buying it at 4.75p. Thus the spread between the two prices is 0.5p, or 10%, of its 5p mid-price. That is the fat profit the broker can make from dealing in these stocks. Investors in such penny shares pay a huge price to pick up these companies.

Contrast this with the efficient market in Barclays (LSE: BARC). At the moment brokers are selling these shares for 2057p and buying them for 2056p. That represents a tiny 1p, or 0.05%, spread between the two prices, such is the competition with dozens of brokers willing to make a market in Barclays shares. In comparison only a handful of brokers makes markets in penny shares.

Penny shares are also more susceptible to rumours due to their small market valuation. Their prices can be moved significantly even when only a handful of shares are traded. Most rumours that circulate about penny shares are pure fiction. So if you've got penny shares their value is much more likely to be determined by rumours from unknown and unreliable sources than the fundamentals of the business. For all these reasons, investors starting out should avoid penny shares. The risk of picking the rotten apples far outweighs the rewards of picking the rare good one.