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Pandora Media Inc (P) and Zynga Inc (ZNGA) Among Hedge Funds’ Favorite Penny Stocks

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Investing in penny stocks is a risky endeavor, but it can also be highly profitable if you pick the right stocks. Many penny stocks cost below $1.0 per share and are listed outside the major market exchanges. In addition, they usually trade over-the-counter through the OTC Bulletin Board and pink sheets. Due to the nature of the exchanges that the stocks are listed on, which are much less regulated and allow companies to not disclose all information and most sources that cover these companies are not always truthful. This is why many penny stocks are considered speculative and high-risk investments.

However, there are companies whose stocks are trading below $5 per share (which the Wall Street considers as penny stocks), and which can result in very substantial returns. There are many penny stocks that are trading on big exchanges like Nasdaq and NYSE, which have to comply with regulations, register with the Securities and Exchange Commission and disclose their complete financial results in 10-Q and 10-K reports. Often these are small but reliable companies that went public in order to obtain financing required for investment in future growth, or companies whose market capitalization slid due to various reasons. In the second case, there might be a chance that the company can stage a turnaround and its stock could rebound, but more analysis is required.

Smart money investors, such as hedge funds don’t overlook penny stocks and many of them even pile into some companies whose shares are trading at below $5. At ams-2010, we collect data from 13F filings of over 600 hedge funds and see how they collectively invest in thousands of stocks. Based on the third-quarter round of 13F filings, there are 19 penny stocks in which more than 20 funds tracked by us reported long positions, and in more than half of these stocks hedge funds amassed over 10% of the outstanding stock. On the next page, we are going to take a closer look at the top five penny stocks that saw the most funds holding shares as of the end of September.

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But before we get to that, we should also mention that simply mimicking hedge funds and following into their penny stocks still involves a lot of risks. Hedge funds, even though they conduct extensive research on each stock pick, they can still tolerate the risk associated with investing a tiny portion of their portfolios into a penny stock. Therefore, following hedge funds’ penny stock ideas should be viewed more of a place to start and conduct a more in-depth analysis. However, there is another way to benefit from hedge funds’ 13F filings. Our strategy uses a proprietary methodology that selects the best stock picks of the best-performing hedge funds in the small-cap space. Since its inception in May 2014, the strategy gained over 67% and outperformed the S&P 500 ETF (SPY) by more than 20 percentage points ().

Having said that, let’s take a look at five penny stocks that hedge funds are collectively bullish on.

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