Using penny stocks for passive income? Here’s why I’m not crazy

Jon Smith outlines his strategy for making passive income with large future potential by investing selectively in penny stocks.

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A penny stock doesn’t have a set definition. However, I usually refer to such a company as having a share price of less than a pound and the market-cap less than £100m. As such, these are smaller companies that have large potential for growth. Usually, I focus on these type of firms for capital growth. Yet I can also benefit from dividend potential. Here’s what I mean.

Small-cap, big potential

The best way I can explain my strategy is by using a real-world example. Crown Place VTC (LSE:CRWN) is a penny stock with a market-cap around £81m and a share price of 30p.

The company is a venture capital trust (VCT), which focuses on investing in privately-listed and smaller businesses. The share price therefore should reflect the value of all the stocks held by the trust at any particular time.

Due to the mixture of profits from selling stocks, dividends from companies and other forms of income, Crown Place pays out a dividend to shareholders. At the moment, the dividend yield is 5.64%, well above the FTSE 100 average yield.

Fundamentally, the business will grow if it’s smart about what it invests in. Over the past year, the share price is flat, but over five years it has grown by 58%.

How my yield could jump in years to come

If I buy now at 30p, I can enjoy the 5.64% yield. This in itself is a good achievement. Yet what if the trust really starts to outperform in coming years and attracts a lot more interest? The share price should rally and the trust will grow. If this happens, the dividend per share should also increase. So instead of taking the last dividend per share of 0.84p, it could turn into 2p, 3p, or even more.

Given that I would have locked in my purchase price at 30p, my dividend yield would change if the payment increases. If the annual dividend went to 3p, my yield would rise to 10%!

This scenario would be harder to achieve with a mature FTSE 100 company. The fact that the penny stock is smaller in market-cap allows there to be far more upside potential for passive income if things go well.

Risks to be aware of

The potential to make sizeable passive income from a stock like Crown Place does appeal to me. However, I need to remember that small-cap stocks are very high risk. Due to a lack of size, relatively small problems or operational issues can cause large problems.

As there isn’t much active buying and selling of the shares, I could also have issues with sudden spikes or falls in the share price if large market orders come in.

Finally, even though the yield is high, I can find some FTSE 250 and FTSE 100 companies with 5-7% yields that I might find safer.

Ultimately, I think my strategy does warrant a small investment. I’m keen on putting some money in Crown Place shortly to test out my theory for the long term.

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 assessed. Consider taking independent financial advice.

Jon Smith 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.

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