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History of Penny Stocks

The word “penny stocks” comes with a lot of connotations. However, it’s a common term that simply refers to stocks that trade at low prices per share off of major national exchanges.

You’ll often hear people tell you that Microsoft and Walmart were once penny stocks, for example. That’s not actually true. In fact, the vast majority of penny stocks are from companies you’ve never heard of.

What’s the history of penny stocks? Where did they come from? Are they all scams? How can you use the history of penny stocks to improve your portfolio? Today, we’re explaining everything you need to know about the history of penny stocks.

What Are Penny Stocks?

Penny stocks are defined by the US Securities and Exchange Commission (SEC) as a security that trades for less than $5 per share, is not listed on a national exchange, and fails to meet other specific criteria.

In the UK, they’re called penny shares, and they’re categorized in a similar way (although the stock price limit is £1). Other countries call them cent stocks.

Generally speaking, penny stocks are cheap shares in a company that are not available through common exchanges.

Over the years, the term “penny stock” has become synonymous with scams and get rich quick schemes. One Google Search will reveal thousands of results promising to make you the next penny stock multimillionaire.

Not all penny stocks are a scam. However, penny stock markets are abound with low-quality companies, shadow organizations, and pump-and-dump schemes – and a few legitimate companies mixed in their for good measure.

Why Are Penny Stocks So Attractive to Investors?

Most major investors stay away from penny stocks. However, even reputable investors will sometimes participate in the penny stock market.

Many of those who invest in penny stocks are attracted by the cheap price-per-stock and the potential for the stocks to gain enormous amounts of value in a short period of time.

“Get rich quick” schemes are as old as human civilization. Everybody would like to make a lot of money in a short period of time. Penny stocks are viewed as one way to get there.

It’s true: investing in the right penny stock could help you earn returns over 1,000%. However, there are some major risks with penny stocks.

The Risks of Penny Stocks

Penny stocks, for the most part, are considered high-risk stocks. Most of them have low market capitalization and are highly volatile: you can gain a lot of money by investing in penny stocks, but you can also lose a lot of money as well.

In many cases, penny stocks are subject to “pump and dump” schemes, where they grow in enormous value over the course of a day before plummeting in the afternoon – often for no apparent reason other than mass hysteria and hype.

One of the biggest problems with penny stocks for investors is the lack of liquidity in the market. Conventional exchanges perform millions of trades every day and have high liquidity. That means you can buy or sell your stocks quite easily. If your stock is dropping in price, you can match with a buyer who wants to buy your stock at that price.

With penny stocks, liquidity isn’t quite as common. This lack of liquidity makes it difficult for holders of a stock to cash out of positions.

With those risks and warnings in mind, let’s take a look at the history of penny stock investing.

Penny Stocks Are As Old as the Stock Market

Penny stocks have existed in some form or another for as long as stock markets have existed. There’s very little information about the early history of penny stocks. However, we know that companies offered enormous numbers of shares in their company for pennies a share – even dating back to the 1800s and early 1900s.

After the 1929 Stock Market Crash, however, the US federal government realized it needed to overhaul securities regulation and bring an end to the unbridled speculation surrounding penny stocks.

In the government’s eyes, this speculation was what caused the stock markets to crash  in 1929. Increased regulation would help investors avoid low-quality, value-less stocks while promoting stocks from more reputable companies – or at least, that was the idea.

Securities Exchange Act of 1934

In 1934, the US government passed the Securities Exchange Act, which helped to bring order to the world of penny stocks. As part of this act, the SEC defined penny stocks as all equity securities that were trading for less than $5 and unlisted on any national stock exchange.

After the 2007-2008 stock market crash, this definition would change again. The SEC added the caveat that in some situations, penny stocks could be traded on US and foreign securities exchanges.

However, in most situations, the word “penny stocks” refers to the definition defined in the Securities Exchange Act of 1934, when penny stocks were classified as cheap stocks sold off of major national stock exchanges.

What happens when a stock is sold off a major national exchange? It means you need to exchange it over the counter – or OTC. Thus, most penny stocks are available through OTC stock markets.

Over-the-Counter Markets Added New Definitions and Tiers for Penny Stocks

The penny stock market remained relatively quiet throughout most of the 20th century. The lack of global communications platforms – like the internet – prevented penny stocks from becoming a widespread trend.

During this time period, penny stock orders needed to be placed over the phone. Investors couldn’t find penny stock information in newspapers. Information on penny stocks was difficult to find.

Nevertheless, penny stocks still existed. Over-the-counter markets during this time created tiers defining the different types of penny stocks.

Penny stock tiers varied. Ranks were chosen based on how much information a company disclosed to investors and others.

The penny stock companies that issued annual financial reports were considered top tier (yes, just issuing annual financial reports made you better than most penny stock companies).

Meanwhile, the lower tiers of penny stock rankings were reserved for companies that didn’t appear to have actual business and refused to disclose any information to investors.

Many of the top tier penny stock companies would actually file regular SEC disclosure reports. Such companies were regulated as OTCBB companies, which stands for Over the Counter Bulletin Board. That name comes from the fact that the Financial Industry Regulatory Authority (FINRA) would trade the best penny stocks on their “Over the Counter Bulletin Board”.

These top tier companies were also labeled as “pink sheet” penny stocks. This name was related to the fact that companies printed quotes on pink paper before circulating them – by hand – to investors, regulators, and the general public.

Despite these various penny stock trading systems, penny stocks remained relatively unknown up to the mid 1990s. It was difficult to find penny stock information in business journals or through the general media. Trades were performed through telephone.

Nevertheless, penny stocks were still a rapidly growing part of stock markets. As global communications and stock market activity increased, penny stocks were becoming increasingly well-known. By 1989, according to an estimate, American investors were being cheated out of “at least $2 billion a year” by schemes involving penny stocks. Many of those schemes, as you’ll learn below, were run by the mafia.

The world of penny stocks really took off, however, when the internet was invented.

The Rise of the Internet and Penny Stocks

Starting in the mid-1990s, penny stock trading exploded with growth, fueled by the spread of the internet around the world. Prior to the internet, the only real way to trade penny stocks was by phone.

Now, with the internet, penny stock discount brokers emerged, offering online platforms where traders could buy and sell penny stocks at discount rates. Investors were lured to penny stocks by the promises of cheap trading fees and the chance of making enormous profits on tiny investments.

Throughout the 1990s, new investors entered the stock market. Some made thousands of dollars. Most, however, did not.

The FBI and Mafia Get Involved in Penny Stocks

All of this penny stock activity led to the attention of federal regulators. Federal regulators – including the FBI – had actually been monitoring the penny stock markets since the 1970s, which is when the Mafia started to influence the markets.

The most notable Mafioso involved in penny stock manipulated was Lorenzo Formato, who would later testify in congress that he promoted and sold penny stocks while being involved in organized crime. His testimony revealed “rampant” involvement by the mafia in penny stock markets and penny stock manipulations.

As a result of Formato’s testimony, the government passed the Penny Stock Reform Act in 1990. This appeared to have little effect on the penny stock world, as the mafia continued to manipulate the penny stock market throughout the 1990s.

Fueled by the internet, the mafia’s involvement in penny stocks became more and more rampant. Investors had trouble determining which penny stocks were legitimate (if any) and which were pump and dump-style schemes operated by the mafia.

In May 1997, the FBI conducted a sting operation against Louis Malpeso, Jr. The FBI charged Louis with conspiring to commit securities fraud to inflate the prices of a penny stock. Louis and his two co-defendants pled guilty.

LEXG’s Direct Mail Campaign: Illegal Promotion or Legitimate Hype?

In many cases throughout penny stock history, regulators struggled to distinguish between illegal promotion and legitimate hype. When someone was promoting a stock, did that just mean they were excited about a company – or were they illegally inflating the value of a stock?

The best example of this was with a company called Lithium Exploration Group, or LEXG in the late 2000s. That company’s market capitalization soared to a whopping $350 million after they launched a successful direct mail campaign.

That direct mail campaign touted the benefits of lithium exploration, including its increasing growth in production across the world. During this time, the lithium industry was legitimately exploding with growth. LEXG’s direct mail campaign promoted itself as one company poised to capitalize on the hype.

Unfortunately for investors, the company’s form 10-Q (which was filed within just a few months of the direct mail campaign) revealed that LEXG was indeed a lithium company – but it had no assets. Its revenues and assets weren’t just small: they were absolutely zero (Source).

Did Microsoft and Wal-Mart Really Used to Be Penny Stocks?

When you talk to penny stock “experts”, they’ll often tell you that companies like Microsoft and Walmart began lives as penny stocks.

You might think that claim sounds reasonable. After all, we’ve all heard of stories of janitors at Google and Microsoft becoming millionaires because they received a few stocks as compensation early in the tech company’s history.

When you check the price of these tech companies, you can actually see that some of them appear to have been penny stocks way back in their early history.

Unfortunately, these histories show the “adjusted stock price”, which takes into account stock splits.

If you take a closer look, you’ll realize that Microsoft traded at $21 in its early days, and Wal-Mart traded at $16.50, although the prices adjusted for splits were 8 cents and 1 cent, respectively.

This is one of the biggest fallacies of penny stock investing. If someone ever tries to tell you that Wal-Mart or Microsoft were penny stocks, tell them you’re not falling for the “adjusted stock price” fallacy. Investopedia goes into better detail about the math behind this process here.

Have Any Big Companies Started Out as Penny Stocks?

You may be wondering: throughout the entire history of penny stocks, has any company really “beat the odds” and made it big? Are there any Amazons, Googles, Apples, or Microsofts hiding within the penny stock world?

The NY Times did a good writeup on this question in 2008. Reporter Floyd Norris looked at the lowest stock price of some of the world’s largest tech companies. He found that Intel once sold for 16.1 cents back in 1974, although this was the split-adjusted price. The actual trading price that day was $15.50. Paying $15.50 back in 1974 would have netted you 96 shares today (at least, by 2008 numbers).

Commenters listed a number of examples of companies that have made it big after selling shares for less than $5 (the definition of a penny stock). Some notable examples included Apco Argentina (APAGF) in early 1985, along with an Australian mining company named Fortescue Metals Group that was trading for under 3 cents back in 2003. In 2008, they produced 100 million tonnes of iron ore every year.

So yes, a number of big companies have come out of the penny stock world. However, genuine success stories are few and far between.

What Does the Future of Penny Stocks Hold?

Penny stocks, for most of modern history, have been associated with scams and pump-and-dump schemes. Investors are attracted to penny stocks for their cheap price and perceived high returns.

Investors will see a penny stock priced at 10 cents and think, “Hey, if that stock goes up by just 5 cents, I’ve made a 50% return.” In reality, that stock could just as easily go down by 5 cents, crushing your investment in half. Investors tend to focus on the upside of penny stocks – not the downsides.

Unfortunately, the penny stock market shows no signs of slowing down anytime soon. They’re largely unregulated, and they appeal to a niche group of investors on the internet who either:

  1. a) Enjoy the high-risk, high-reward game of penny stocks and are using “play money”
  2. b) Foolhardy investors lured in by online programs promising gains of 20,000% and higher

Regardless of whether you’re buying penny stocks or blue chip stocks, the lesson remains the same: invest carefully and do your research before you buy.

 

 

About Johnson Hur

After having graduated with a degree in Finance and working for a Fortune 500 company for several years, Johnson decided to follow his passion by embarking on a path to the digital world. He has over 8 years of experience with large companies setting marketing strategy and he likes to workout in his spare time.

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