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Here are 2 pros and cons of buying penny stocks

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British Pennies on a Pound Note
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Penny stocks are listed companies that have a share price below 100p. This definition means that there are penny stocks within the FTSE 100, FTSE 250 and other wider indices. I think there are some misconceptions with what it means to buy penny stocks. At the same time, some reasons for concern are valid. So here are my main pros and cons of getting involved with such shares.

Undervalued penny stocks

One of the main reasons why I’d buy a penny stock is because it could be undervalued. Especially for larger companies that previously had a share price in excess of 100p, a low current share price could offer me a good buy. If earnings have remained fairly constant despite the share price falling, this could offer a low price-to-earnings ratio. Buying shares here could allow me to see large gains if investors see value in the stock in the future, with a fairer valuation.

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This pro can also be turned into a con though. A low share price could indicate that the company is simply not performing well. For example, Cineworld became a penny stock during the stock market crash last year. However, the share price has been unable to push back above 100p and is currently trading at 62p.

As I mentioned recently, I think the share price could fall further before offering me good value. It has a high cash burn rate of $45m a month, as well as high debt levels. So I would stay away at the moment, despite what some might consider a cheap price.

Growth potential

Another potential benefit from buying penny stocks is that these tend to be smaller, lower capitalised firms. Although there are exceptions, I do find more penny stocks when I look at the AIM market, or companies that sit outside of the FTSE 250. 

There’s a good argument that it’s these smaller firms that can offer me the greatest long-term growth potential. This kind of stock has the ability to grow and move up the scale, eventually perhaps entering the FTSE 250 and even FTSE 100. With such an increase in market capitalisation, this will mean a higher share price (and make it less likely it would have a price below 100p).

The gains for me from buying now could be very high, higher than I could get from a mature company that has already achieved peak growth and revenue.

This also does flip into a potential risk that I need to be aware of. Investing in smaller companies typically carries a higher risk than larger counterparts. The main reason behind this is that larger companies have a proven track record and have built a large presence in the market. These factors should help them weather tough times better than smaller firms.

On balance, investing in penny stocks carries with it both risk and reward. As an investor, my job is to weigh up a business and decide whether the reward outweighs the risk, or vice versa!

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jonathansmith1 and The Motley Fool UK have no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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