Buying a share for pennies that ends up being worth pounds is an investing dream. Sometimes a penny stock really does explode in value. But many cheap-looking companies end up getting even cheaper!
So while I do own some penny stocks, I pay close attention when selecting them for my portfolio (as I do for any investment).
Here are five potential red flags I consider.
1. A business model that can’t be fully understood
When buying any share, I always like to stick to what Warren Buffett calls my “circle of competence”.
Sticking to what I think I comfortably understand applies to penny stocks too.
Some have opaque business models and are much bigger on jargon and grand claims of future potential success than explaining how they actually do (or plan to) make money.
2. Prospects tied to one unproven project
“If this project works, our company can make millions” is the pitch for quite a few penny stocks.
In a way that is understandable. Some enterprises require a lot of upfront expenditure and if things go well can be very lucrative. Mining and oil exploration penny stocks can often be like this.
But two things put me off such opportunities even though some end up being great investments: a lack of diversification and an unproven business model.
3. Long history of underperformance
Past performance is not necessarily a guide to what will happen in future.
But when a company has a compelling investment case today yet has already been listed for many years, one question I ask myself is whether anything has changed that could help it achieve success now if it has not done so previously.
4. Inflated cost base
Some (but by no means all) penny stocks are little more than a way for advisers and directors to burn through a company’s cash paying themselves handsomely.
Looking at a company’s accounts is a useful way to find out whether a business is focusing cash on business development, or just spending it like a drunken sailor.
5. Elevated political risks
All companies face political risks. But a multinational like Unilever or Shell typically has a broad geographic spread of businesses. Such companies usually have experience of handling events like a sudden land expropriation plan in a remote country.
However, for a penny stock focused on operations in a single, volatile country such an event can be a financial disaster.
Putting the theory into investing practice
As an example of how I use my approach, consider Serabi Gold (LSE: SRB).
Lately, this share has – fittingly enough – been a goldmine for investors.
The former penny stock has moved up 166% in a year. Over five years, the growth has been a more modest (but still impressive) 56%.
Still, as a long-term investor, I note that the Serabi Gold share price is less than a sixth of what it was 15 years ago – and down 99% since a 2007 high. Ouch!
The company has been growing strongly. It aims to double production by the end of this year. Post-tax profit for the first nine months of last year almost quadrupled to $18m. This ticks some boxes for me, positively.
But Serabi’s focus is roundly on gold and on mines in one geography (Brazil). That risk concentration alone puts me off investing.
