Here’s my golden rule when investing in penny stocks and 1 risky pick I like now

Ben McPoland outlines his thinking on investing in penny stocks and picks out one he likes despite it dropping nearly 20% in a month.

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British Pennies on a Pound Note

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I’m always on the hunt for high-quality growth and dividend shares to build out my wealth. My fishing pond is primarily the main FTSE index, where the larger and more established companies reside. In addition to this, though, I do like to snag the odd penny stock for the riskier side of my portfolio.

However, I have a rule for investing in these market-cap minnows, which I’ll get to shortly.

Why are they risky?

Firstly, it’s important to understand what people mean when they talk about penny stocks, as well as the positives and negatives of investing in them.

Penny stocks, sometimes referred to as penny shares, trade with a share price below £1. And these small firms also have a market cap below £100m.

Due to their small size, many are unprofitable and a fair few are even pre-revenue (they have nothing to sell yet). Without much money to invest in research and development and new products, most never leave the penny stock arena. So they generally offer a higher level of risk.

Unfortunately, due to the low float of shares, they’re also prone to pump-and-dump schemes. These are when someone buys a large amount of stock and hypes it up, before selling it for a profit after other investors have piled in and pushed up the price.

This year, RC365 displayed all the hallmarks of this hype cycle. The stock chart says it all.

My rule for investing

Given the risks then, my golden rule is a pretty simple one. I never invest more than 0.5% of the value of my portfolio in a single penny stock, no matter how much I like it.

So if I had a £100k portfolio, I’d only put a maximum of £500 into a penny share. And I never have more than a handful in my portfolio at any one time.

An example of a big winner

Having said all that, they can also offer a higher potential reward.

Ashtead, for example, was a penny stock 20 years ago. Now, it’s a £20bn FTSE 100 firm and the second largest equipment rental specialist in North America.

Obviously, Ashtead is a very rare case. But it does show what is possible.

So, which penny stock do I like the look of right now?

The risky pick

At 39p per share, I’m bullish on the long-term potential of SRT Marine Systems (LSE: SRT). This is a £76m market cap firm that sells technology to helps vessels and waterway authorities so they can understand what is happening.

Now, the risk has been heightened here because the firm recently reiterated that results would be heavily weighted to the second half of FY 2024. Investors were spooked by this and sold off the stock. If H2 comes in light, it could fall further.

Yet I think this presents an opportunity. The company is a global leader in martine surveillance, which is a growth area due to the global adoption of the automatic identification system (AIS). Like air traffic control, this is a tracking system that transmits a ship’s position, identity, course, and speed.

Meanwhile, the shares look cheap on a forward P/E ratio of just 10. That could prove to be a very lucrative entry point, and I’m considering adding it to my holding.

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.

Ben McPoland has positions in Ashtead Group Plc and Srt Marine Systems Plc. 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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