Price is what you pay but value is what you get. That aphorism came to mind recently when reviewing some UK penny stocks. I do think it’s possible to find some value in the lower priced reaches of the stock market. But a lot of penny stocks I wouldn’t touch with a bargepole.
Here’s how I go about choosing UK penny stocks for my portfolio.
Know what I want
A lot of people hunt for penny stocks by starting with the lowest price and working up.
But there’s no way I would visit my local supermarket and shop by finding the cheapest item in the whole building and moving upwards by price. Instead, I have a shopping list, or at least a broad sense of what I am looking for.
It’s the same for me when it comes to shares, whether penny stocks or more costly ones. I first look at business areas where I see profit potential and feel competent to judge companies. Only then do I start to consider the merits and demerits of individual companies. Just like legendary investor Warren Buffett, I am keen to stick to my “circle of competence”. I stay within that circle when choosing UK penny stocks.
Look for great businesses
At this point I can start to look at individual penny stocks I might want to buy. But I still don’t think about the price. Instead I research what are the attractive looking businesses in a given area.
For me as an investor, an attractive looking business is one that will be able to return me over the long-term a far greater amount of money than I put into it. There are different ways a business could manage that, but I ask myself questions such as: how big is the potential market? What competitive advantages does this company have? How profitable is this market likely to be in the future?
For example, consider Lloyds, which trades in pennies not pounds. I see continued demand for banking services and I think the bank’s mortgage expertise could be a competitive advantage. Then again, it could also be a risk. What if a recession comes, for example, and mortgage arrears increase? As the UK’s biggest mortgage lender, that could be bad news for the bank’s profits.
Once I decide I like the outlook for a business, I turn to its valuation.
Valuing UK penny stocks
Value, remember, is what I get. It’s not the same as price, which is what I give.
So, how do I value penny shares? Basically, the same way I value any share. For example, I consider the likely future earnings. I also look at the balance sheet to see if there are any nasty surprises there, such as high debt levels.
Free cash flow is always a useful metric, and I pay close attention to it when valuing penny shares. A penny share may seem to have a low price-to-earnings ratio. But what if free cash flow is much lower than historic earnings? It could end up being a value trap.
If the share price is significantly lower than my valuation of the company, I may start to consider buying such a share. But that’s because of the value it offers – never the price alone.
