Zoom Video Communications stock soared after its initial public offering, rising more than 70% on its first day of trading, valuing the company at more than $17 billion, excluding stock options and restricted stock.
Impressive, but Zoom Technologies stock (ticker: ZOOM) did better. It soared 6,900 percent in the month leading up to the Zoom Video Communications (ZM) IPO. The two companies aren’t connected. So, we ask, which firm is the better investment?
That’s a trick question. Zoom Technologies isn’t an investment. It’s a penny stock. Zoom Technologies isn’t a real business. It hasn’t recorded any sales since 2011.
Investors need to avoid penny stocks and the people who recommend buying them.
Penny stocks are a class of securities that trade “over the counter,” off large U.S. stock exchanges because penny stocks don’t meet the listing criteria for exchanges like Nasdaq.
They are often the stocks mentioned by investor newsletters with headlines like, “this stock rose 10,000 percent and our next pick will do even better!” It sounds enticing, like easy money. It is easy money, but not for the ones following the newsletter’s advice.
The ones writing the newsletter are making easy money. They are selling their position, slowly accumulated, to unwitting investors buying into a penny stock with a sharply rising price. It can take the form of a classic pump and dump scheme.
New investors should remember an important dynamic about trading stocks. Namely for every stock buyer there is a stock seller. And it’s often new investors buying that drives up the price of a penny stock. But when new investors are done buying, trading volume dries up. There is no one left to sell to.
In the stock market, volume always precedes price. Meaning big stock price moves, whether in the stock of Zoom Video or Zoom Technologies, are always associated with above average stock trading volumes.
Think of it this way. Penny stock Zoom Technologies traded an average volume of about 20,000 shares a month—that’s right, every month—in the six months prior to March. That means it would take an investor months of patient buying to accumulate a position of 20,000 shares, substantially impacting the stock price.
The following six weeks, before Zoom Technologies stock hit its 52-week high of $5.76, almost 1.2 million shares exchanged hands. That’s 60 times the old monthly average volume.
If you bought, say, 100,000 shares in March or April and volumes settled back to normal it could take you forever to exit from the position. And once the stock starts to drop there no new buyers available to take the position off your hands. You’ve exchanged hard earned income for worthless paper.
The lack of liquidity is one reason to avoid penny stocks, but you should avoid them just because they are penny stocks.
Penny stocks don’t have to be as nefarious as pump and dump schemes. They can be pure slot-machine casino speculations too. Some of the traders who noticed Zoom Technologies was, well, zooming, probably bought and sold shares in less than a day. Speculative trading doesn’t change the fact that Zoom isn’t a real business. The terminal value of a company with zero sales is, you guessed it, zero.
Eye-popping returns generate investor interest (and greed), but penny stocks aren’t the way to get rich. After all, Zoom Technologies’ stock price run didn’t generate all that much wealth. The stock went from a fraction of a penny to $5.76 a share before losing 77% of its value on April 16.
The move from the trough price of less than a cent to the peak price of $5.76 created about $17 million in stock market value. That may sound like a lot of money, but consider $17 million is the swing in value every time Amazon.com(AMZN) stock moves 3 cents.
Zoom Video Communications has no connection whatsoever with Zoom Technologies. In fact, Zoom Technologies has no business at all. It is likely that Zoom Technologies stock started moving just because of name association. Hopefully, it wasn’t because less than savory characters were preying upon naive investors.
Now is a good time to review penny stocks because of hot IPOs, like Zoom Video Communications. IPOs generate a lot of interest from new investors, and Barron’s often fields questions from curious readers about investing in new stocks.
Hot IPOs and penny stocks are linked in one way—big one-day stock market gains. Just remember all gains aren’t created equal and penny stocks should be avoided. Get rich quick schemes don’t exist.