Penny Shares: Back To The Basics

All I wanted to do was pay for my six slices of dried pancetta…

But it’s never THAT easy shopping in Morrison’s on a Sunday afternoon – especially when you’re stuck behind a family of five screaming kids fighting to unload the trolley.

So I did what anyone would in that situation… I concentrated all my attention on the conversation of the two guys behind me...

And funnily enough it gave me the idea for what I want to talk about with you today.

They were discussing what exactly defines a penny share…

I won’t recount what they said (they may be readers!) but needless to say, neither had any real clue.

So I thought today we’d go back to basics…

What actually defines a penny share?

Most investors will sight a stock’s upper price limit. And in the UK, some brokers require a share price of less than £1.00, while others set the ceiling at £3.00.

Whichever way you look at it, penny shares are the fun side of investing. Imagine if you’d bought shares in Microsoft when it was mere pennies only two decades ago?

Yes they can be extremely fun to trade… but also, unfortunately, it’s got a crooked side…

As you know, the younger the company in which you invest, the greater the risk.

The risks and rewards are greater not least because penny shares have a thin market.

What do I mean by ‘thin market’?

Well, a 10p stock may rise 50% on a tiny bit of good news, whereas an old economy blue chip stock could only wish for the same reaction. But the flip to the other side of the coin and the penny share can fall more sharply than its larger cousin.

And if that wasn’t enough of a recipe for the investment sweats, its price at any given time may bear no relation to the stock's underlying value.

If the market predators are showing an interest, a penny stock could prove very profitable. The share price can soar on speculation that there may be a contested takeover bid at a considerably higher value than the current share price.

That’s why you won’t always buy penny shares on value grounds.

You have to be ready to nip in and out of stocks and keep a sharp eye on share price changes.

The choice of market is huge, and whichever one you choose can make a difference to the company's profile, its liquidity, and its expenses.

A company can be quoted on the London Stock Exchange's main market OR on AIM. Or it may even be PLUS-quoted…

It’s one thing knowing where the next beauty is quoted. It’s another trying to find it!

How to pick the penny share winners

Contrary to what many private investors think, penny shares are NOT subject to the usual stock valuation rules. The level of PE ratio, for example, will rarely make much difference - the share price is highly susceptible to fluctuating market perception.

A penny stock will ideally have a net asset value per share that is higher than the share price. This will help it to survive through lean times. That way if a company is wound up, the liquidator will distribute to shareholders in proportion to the company's assets. The more assets, the more money the investor will claw back if all goes belly-up.

And that’s one reason why I’d be cautious about ploughing any of your money into under-researched internet stocks. They have few or no tangible assets. The share price may rise or fall rapidly within weeks.

If you are thinking about investing in a technology company, check that it has significant revenues. Look for earnings either now or in the foreseeable future. Also, look for a strong business model. For promising companies without earnings, a favourite valuation method of many investors is the price/sales ratio – but that will be for another time!

(Basically an internet company’s assets are in cyberspace… you can’t see or touch them. And that’s how most investors got burnt in the tech boom of 2000.)

Try to predict rather than reflect trends in your stock selection.

If, for example, you discover that a pharmaceutical company is about to publish the anticipated good results of the drug tests they’ve been carrying out, invest early – especially if this is not yet reflected in the share price.

If the test results meet expectations, the share price could skyrocket taking your investment with it. But as always, on the flip side, shun shares that are blatantly over-puffed.

When you assess the company's management, look for leadership as well as any required technological expertise. The two don’t always come together.

A positive change in management may send the share price soaring.

I’ll be going ‘back to the basics’ in a few issues of Penny Sleuth over the next few weeks. So stay tuned.

But for now, I’ve got some pancetta to eat.

Happy investing

The Penny Sleuth