What is it about penny stocks that lures new or young investors? They are volatile, mostly unprofitable and regularly dilute shares in order to raise new capital.
Well to begin with, we have all day dreamed about buying that one life changing penny stock. An Amazon or a Google back when they were just a drop in the ocean. We think to ourselves, 'had we only known', and calculate what a $10,000 investment back then would be worth today. But, is there a way knowing what the next great moonshot will be?
The answer is unfortunately, NO! However, there are some characteristics that can help increase your chances of finding the next big thing or at the very least, make market beating gains.
Now when we say investing, we mean exactly that - a medium to long term buy and hold strategy. Compared to day trading, investors are theoretically exposed to more risk when holding on to companies for long periods of time (which is why diversification is important). The risks are compounded when we add penny stocks into the equation.
(Note: Our definition of a penny stock is anything with a market cap under 500 million USD)
Therefore, we must be very selective about which penny stocks should even be considered being placed into our portfolio for the long term.
These are our rules for selecting penny stocks:
1. The company must have a lot of information available about itself
This means the company trades on a respectable exchange which in North America are:
New York Stock Exchange
Toronto Stock Exchange
No pink or grey sheet nonsense. The reason is because companies on the big exchanges mentioned are more regulated and have to disclose any material information within certain time frames. However, the smaller exchanges don't have such requirements and the companies barely disclose anything.
2. Revenue needs to be growing
Simply put, if revenue doesn't grow consistently, neither will the share price in the long run. Revenue needs to grow year over year in order to validate that the consumers are responding well to the companies products or services.
3. Strong balance sheet
A company with a lot of cash on hand and little debt is more likely to survive than a company with the opposite. Familiarize yourself with solvency ratios such as the quick ratio or current ratio. If the company has debt, is it growing at an unhealthy pace year over year? Is it manageable? Click here to learn the basics of how to analyze a balance sheet.
4. Adequate share volume
There needs to be enough liquidity in the stock for you to be able to easily buy or sell your shares.
5. The industry needs to be growing
It's one thing to invest in a small cyber security company, it's another to invest in a small newspaper company. Another thing to consider is what kind of headwinds or tailwinds are expected to impact the industry?
6. Invest in what you know
If you are going to take the risk of investing in a penny stock, then it is critical that you invest in an industry that you fundamentally understand. How else are you going to evaluate if the company has what it takes to become a moonshot?
7. Define the competitive advantage
What makes the company special? Has it developed a new technology that will disrupt its industry? Does it have the best operating efficiency? Are there high barriers to entry?
8. Does the company generate positive cash flow?
Ideally you want a company that generates positive free cash flow on a yearly basis. However, that's not usually the case with small companies who are focused on growth. Therefore some acceptable alternatives are as follows in order of most ideal to less ideal:
9. You must have some idea of how to value the company
Whether it's absolute or relative valuation, you have to be able to assign a value to the company. Is the company overvalued, undervalued or at a fair price? If the company has positive free cash flow, we can use the discounted cash flow method to value it. If not, we could use alternative methods such as price to sales ratio, enterprise value to EBITDA, price to earnings or price to book.
10. Technical Analysis
Try using technical analysis to get a good entry. Given the increased risks associated with penny stocks, we need any advantage we can get. The last thing you want to do is buy a penny stock that has a long down trending chart. Here is a link to a technical analysis blog we wrote, and a link to another one here.
Once you compile a list of penny stocks that meet the criteria outlined above, narrow the list down to what you believe the top 3-5 companies are. If you decide to take the plunge and make the investment it's best you ease in to your positions. This means that if you are planning to invest a total of $1000, break it up into smaller purchases (for example, 4 buy orders of $250 at a time). Spread out the purchases over a few weeks in order to gauge the stock price and give you time to re-evaluate your positions before committing more capital.
As already mentioned, investing in penny stocks is very risky business. You should only get involved if you have the stomach to handle volatility and capital you can afford to risk. Although the method we outlined above can help increase your chances of making successful investments in this area of the market (the way it has helped us), nothing is ever guaranteed. Thus, you need to diversify your portfolios with different types of asset classes (bonds, real estate, etc) as well as stocks across multiple sectors.