Penny stocks are notoriously volatile and risky. And yet the promise of potentially explosive returns keeps attracting growth investors into this region of the stock market.
After all, it takes just one thriving business to reap triple or even quadruple-digit returns, undoing most, if not all, losses created by the firms that failed to live up to expectations.
But finding such winners is far easier said than done. In fact, more often than not, penny stocks will surge on hype only to collapse a few weeks or months later. And while there is some money to be made from predicting this cycle, doing it successfully is near impossible. Don’t forget timing the market is a loser’s game.
The real money is made from identifying promising companies with the ability to explode in the long run without having to rely on miracles. And when it comes to searching for such opportunities, there are three critical factors I pay close attention to.
1. Detecting obscurity
Small-cap companies on the London Stock Exchange follow different regulatory rules than large-cap enterprises. The reporting standards are far less strict. And management teams don’t need to be as transparent with the information they provide investors.
Obviously, this creates a potential problem. In my experience, companies that are deliberately vague or leave out key details relating to their financial statements can be a red flag. This is especially true if the firm also stuffs meaningless adjectives throughout its annual report.
Using fancy buzzwords, like machine learning, gene editing, or blockchain technology, is an excellent way to build hype and momentum. But all too often it serves to mask a mediocre operation, disguising itself as a next-generation disruptor.
Simply put, if a firm is more concerned with boosting its stock price in the short term than raising more money through equity, then it’s often a sign to steer clear.
2. Track record
History is a poor indicator of future performance. However, a company’s track record can provide valuable insight into the quality of its leadership. A business that has systematically hit or exceeded its targets suggests that the CEO has talent in capital allocation – a valuable trait.
But a group consistently making promises but never delivering, or repeatedly blaming the macroeconomic environment, suggests they may not be as talented as they think.
In the world of small-caps, having smart leadership can be the deciding factor over which firms successfully penetrate a market. And so I’m looking for companies that under-promise and over-deliver rather than the other way around.
3. How liquid is the stock?
Even if I identify one of the best penny stocks to buy now, pursuing this investment may still be a terrible idea if the trading volume is too low. This indicates a lack of liquidity, making buying and selling shares far harder.
Even if the stock price has increased substantially, if the average trading volume is too low, I will likely have to sell the stock at a steep discount to its current market price.
Obviously, investigations into a penny stock doesn’t end with these three factors. However, by using them as a filter, I can eliminate many poor investments from consideration.
