This penny stock grew 20% last year. Can it again in 2022?

Penny stocks can be risky investments, but they have the potential for massive upside under the right circumstances. James Reynolds discusses his thoughts on how to find good investments and one he’s adding to his portfolio.

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Penny stocks are companies whose shares are valued under £1. These companies are often new and can be quite small when compared to the bigger players on the market. Sometimes they are simply worthless. But other times they are incredible opportunities.

Finding good penny stocks

The trick is to understand the business then calculate whether there is a wider market for what it’s offering. Is it currently underutilized, or has it reached its potential? Does the business need to change to survive?

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For example, Zephyr Energy, a mining and petroleum investment firm, trades on the LSE for 7.29p today. But does the future look good for petroleum products? Recent fuel shortages may have pushed up the price of oil but the climate crisis requires that these companies become a thing of the past. Zephyr could pivot more to rare mineral mining, but it simply doesn’t look like it’s worth the risk to me.

A potential winner

By comparison, the world continues to invent new need for tech and data collection. The historian and writer Yuval Noah Harrai has written extensively about how data will become the vital resource of the future and we have seen how companies that trade in it have become some of the most valuable on the planet. Most tech companies already cost hundreds or even thousands of pounds per share but the UK’s own Idox Group (LSE: IDOX) currently trades for just 69p. This is up 20% from 49p this time last year.

Idox Group develops specialist software for government and industrial uses. Just a few days ago the Comhairle nan Eilean Siar (Western Isles Council) in Scotland began using software designed by IDOX to collect building and planning data on the local area and there are now further moves to integrate this software into the Scottish national government.

Anyone in the modern workplace knows how quickly tech solutions become entrenched in I.T infrastructure. Once it becomes entrenched, it then holds a near guaranteed recurring income for years or even decades to come. We can see this already in action at Idox. Between financial year 2020 and 2021, more than half of its revenue (£17.1m) came from recurring customers.

If this local council project goes well and we see further adoption by others around the country, then I think Idox has a good chance of breaking out of the penny stock range.

Risks and reward

The biggest risk I can see is that, right now, Idox has a razor thin profit margin. This may be down to it being a relatively new company and it still allocating capital to growth. Just this year it acquired Aligned Assets, another UK-based software company.

But if these investments don’t pay off, it could quickly fall back into being unprofitable. Such are the risks with penny stocks.

However, Idox has expanded its operations overseas and continues to offer its services to private companies and institutions. I’m focusing on government contracts as they are very lucrative and, once adopted are usually hard to dislodge. Idox currently makes 77% of its revenue from the public sector, but potential expansion into the private sector should not be ignored.

Provided Idox can beat out the competition and hold onto its contracts, the potential for growth domestically and overseas seems exponential.

I’m eager to add it to my portfolio.

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James Reynolds has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Should you invest the value of your investment may rise or fall and your Capital is at Risk. Before investing your individual circumstances should be considered, so you should consider taking independent financial advice.

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