Strangely, there is much debate about the exact definition of penny shares. It may seem obvious that the term covers any share costing less than £1. But in a recent paper on the subject, the Financial Services Authority designated them instead as shares with limited liquidity, i.e. hard to buy and sell in quantity without moving the price. Specifically, the FSA singled out those with a spread of 10% or more between buying and selling prices.
This view may seem a bit perverse, since it applies to some shares that cost over £1. But it makes a very crucial point - penny shares are not cheap tickets to riches. You need them to rise 12% or more just to break even, after covering spreads and dealing costs. If the mid-price goes down 20% after you buy them and you decide to sell, you will have lost around one-third of your money. That sort of move can happen daily in small companies that are typically quoted as penny shares.
But surely, you say, the huge potential of penny shares more than compensates for the risks? As a rule, no. There is no evidence that penny shares as a class have any more potential to appreciate in price than shares costing more than £1. The reason is simple: Price in itself is not a measure of value. It only becomes a measure of value in relation to other factors, e.g. price-to-earnings or price-to-assets.
So you need to consider penny shares case-by-case in order to determine whether they offer good value or not. If you think about it, this makes perfect sense, since penny shares are not really a coherent class at all. At any given time, they include
...in fact, just about everything except large companies. If all it took to make money were looking down a list of shares and buying those with the lowest face value, wouldn't we all be sunning ourselves in the Bahamas by now?
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