The pros and cons of buying penny shares

British Pennies on a Pound Note

Buying shares for a few pennies, or even fractions of a penny, has to be a good idea, right? I mean, there’s less to lose than buying shares costing pounds, surely. And the potential upside must be higher? Well, investing in penny shares comes with risks.

Firstly, let’s look around for a few very cheap shares on the UK stock market right now. Hmm, there’s an oil and gas explorer priced at well below a penny, even though oil is over $100 per barrel. I see its share price has collapsed over the past five years. Could I have a cheap oil entry here?

And wow, here’s a high-tech company whose shares are priced at less than a tenth of a penny. If I invest £1,000 in this one, I’d become the owner of several million shares. And that’s got to be good, yes? There has been another massive share price crash from its past peak, though.

Many more too

The names of these companies are not important, as there are plenty of other similar ones out there.

Nobody floating a company on the stock market thinks, “Let’s start the shares at a penny, so people will think they’re cheap and buy them“. No, to get down to just a few pennies or below, prices generally have to crash. And that’s usually for the very good reason that something has gone seriously wrong with a company.

Buying penny shares often means buying a company just before it goes bust. And the maximum potential loss is 100%, which is the same for any stock at any price level.

Is there anything good?

This is all a bit down and gloomy, isn’t it? So do I think there’s any upside to investing in penny shares? Yes, I do. But I think we need to examine the definition first. In the UK, a stock is generally considered a penny stock if it’s priced at under £1. Typically it’s applied only to companies with market caps of under £100m, but the upper half of that range can still represent a good-sized company.

Going on that, we can find possibilities like healthcare company Totally, priced at 43p and with a market cap of around £80m. Its share price slumped, but it’s been recovering strongly.

A quick search also finds European Metals Holdings, at 40p and a market cap of £73m. It might be a good one to investigate for its lithium potential, in the face of the rapidly growing electric vehicles market.

Buy penny shares?

I haven’t properly investigated either of these, so I don’t know whether I’d buy them. But I think they show there are definitely companies out there within the penny share definition that are worth some investor research.

Penny shares do tend to exhibit wider spreads between the buying and selling prices than most, which means they need to rise more to break even. So we need to be more careful about the costs of over-trading than usual. For me, even a penny share investment is a long-term investment.

And I think there are profits to me made, as long as I stick to my key penny share rule: don’t scrape the bottom of the barrel.

The post The pros and cons of buying penny shares appeared first on The Motley Fool UK.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has 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.