Avoid penny stocks at all costs!
At least, that’s what blue-blooded Wall Street types swear we should do.
By their definition, any stock trading for $5 technically falls into this classification.
When I talk about penny stocks, though, I’m referring to stocks that trade for less than $1 per share. By my tally, there are currently more than 5,000 such stocks in existence.
Granted, not all of these stocks are destined to be winners.
Indeed, I admit that the penny stock market is full of landmines. For instance, we shouldn’t invest in Lehman Brothers (LEHMQ) just because it’s a penny stock! But this market is also home to goldmines – stocks capable of quickly rallying 200%, 500%, even 1,000%.
And if we know how to sidestep the dangers, there’s truly a fortune to be minted trading penny stocks.
As I promised yesterday, I want to help you do just that by sharing my 10 rules for investing in penny stocks. So let’s get to it…
Penny Stock Rule #1: Administer the Scam Tests
After getting a “hot” tip about a penny stock, many investors commonly wonder if it’s a scam.
Anybody home? Think, McFly. Think!
If we have to ask that question, there’s usually a reason for it. Do yourself a favor and move on to a stock that doesn’t raise any such doubts.
Now, if you simply refuse to believe nothing is ever too good to be true – or you’re incapable of rational thinking when presented with a seemingly can’t-lose penny stock – apply this secondary scam test…
Verify that the company is fully reporting. By that I mean, make sure the company files audited financials and quarterly results with the SEC.
If a company can’t meet those simple requirements, the likelihood of it being a worthy investment is pretty much zero. Don’t take the chance.
Penny Stock Rule #2: Show Me the Revenue!
A cheap stock price is no reason to abandon sound financial analysis. Be picky when investing in penny stocks and insist on finding companies with solid and improving fundamentals.
With that in mind, we should be willing to take a bet on a young, innovative company – even if it doesn’t have any profits. But we should never compromise on sales.
Revenue is the only sure sign that real demand exists for its products. So if a company can’t show you the revenue, show it to the curb. It’s not worth your time or hard-earned investment capital.
Penny Stock Rule #3: Size Matters
There may be riches in niches, but not for penny stock investors.
We need market opportunities big enough to meaningfully increase sales and share prices, as well as attract mainstream attention in the form of a takeover offer. With that in mind, stick to penny stock companies with products or services that address a market worth at least $1 billion. That’s more than enough to do the trick.
Penny Stock Rule #4: Stick to “Smart Money” Magnets
Almost every company gets its start in the private market. And it stands to reason that the companies attracting the most private funds from leading venture capitalists and private equity firms hold the most promise.
By tracking these money flows, we can ensure that we’re one of the first to know about the next wave of visionary companies.
With that in mind, be on the lookout for penny stocks receiving fresh capital from the “smart money,” which includes insiders.
As we recently witnessed with Crossroads Systems (CRDS), it can be a surefire sign that good times are on the horizon. The stock hit a low of $0.69 on October 10, 2013. Shortly thereafter, a prominent insider and value investor started buying shares. Sure enough, less than four months later, the stock is up 315%.
Penny Stock Rule #5: Catalyst Required
An impending event can send a tiny stock through the roof.
Imagine owning a small pharmaceutical stock ahead of FDA drug approval – or a little software company before a major takeover. Such events can make us ridiculously wealthy, overnight.
When hunting for compelling penny stocks, we need to focus on companies with strong catalysts on the horizon with the potential to propel shares dramatically higher. If none exist, the stock will likely be worth a penny indefinitely, which makes it unworthy of our time or investment.
Penny Stock Rule #6: Be Old School… Pick Up the Phone
The information age has produced a generation of lazy investors. Their due diligence goes no further than a few mouse clicks and internet searches.
But I’m here to tell you that the internet is not efficient.
All publicly available information about a particular company cannot be unearthed on our computers. The surest way to verify an opportunity and find out more specifics about it is to pick up the phone! Yes, reach out and call someone.
While CEOs of multi-national, mega-billion-dollar-market-cap companies won’t give you the time of day, executives at micro-cap companies are much more likely to answer your call.
Penny Stock Rule #7: Bet Small to Win Big
By making small bets on penny stocks, we can limit our downside risk and ensure that a total loss won’t torpedo our entire portfolio. As a general rule of thumb, I never invest more than 1% of my total equity portfolio in a penny stock.
If you want to wager slightly more, that’s up to you. But don’t wager too much more, or else you’ll undermine any efforts to reduce risk.
Penny Stock Rule #8: Know Your Limits
Most penny stocks sport lower-than-average trading volumes. If we use market orders, we’ll end up paying more, which ultimately cuts into our profit potential.
Instead, use limit orders to buy penny stocks. And be patient. Penny stocks are notoriously volatile, which means we should never have to chase prices. Eventually, a dip in prices will materialize.
Penny Stock Rule #9: There’s No Crying in Baseball
When investing in such a speculative area of the market, we’re bound to invest in a few duds. It happens. So expect it.
As long as we’re only investing money we can afford to lose, and we limit our bets to small amounts (see Rule #7), there’s no reason to shed a tear.
Penny Stock Rule #10: Don’t Be a Miner
For whatever reason, investors love to go prospecting for penny stock riches by investing in developmental stage mining stocks. Particularly in Canada, where 68% of the companies on the Canadian TSXV exchange are in the mining and energy sectors.
Unless you’re a geologist with a big travel budget – and that’s not any of us – we’re no more qualified to make an investment decision in these types of penny stocks than a newbie prospector with a divining rod.
So don’t do it!
Bottom line: Follow these 10 straightforward rules, and your winners should far outshine your losers – thereby making hunting profits in penny stocks a worthwhile endeavor. Don’t believe me? Give it a try!
Ahead of the tape,
Louis Basenese
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