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Buying Penny Stocks – Tips and Strategies

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What is a Penny Stock

buying penny stocks

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A penny stock is defined as a stock that is trading at less than $5.00 a share. There are several places you can find penny stocks listed including the Nasdaq, S&P 500, Russell 2000 Index, OTCBB, and Pink Sheets. The latter of the two behave slightly differently than major indexes because there is no centralized market and it must be traded through a market maker. When buying penny stocks it is important to understand how the market influences price. Smaller markets usually lead to greater spreads between bid and ask prices and often trade at significantly less volume.

In the rest of this post I will cover how to accurately measure a penny stock, tips for buying penny stocks, and whether or not buying a penny stock can lead to generating huge returns for your portfolio.

How Penny Stocks Are Listed

Major Indices

Businesses on major exchanges that are classified as penny stocks are most likely distressed companies that once traded at a significantly higher price per share. This is not always the case, but to be listed on a major exchange there are strict filings and guidelines a company must adhere to become listed. When buying a penny stock that is traded on a major exchange it is important to understand the reason why it is valued so low.

OTCBB & Pink Sheets

Stocks on the Pink Sheets and OTCBB are either companies that recently became public to raise funds and do not yet meet the requirements to be listed on a major exchange. They can also be formerly listed businesses that are in such turmoil they are no longer listed on a major exchange. It is important to understand that the OTCBB and Pink Sheets market do not have nearly as strict filing guidelines as major indices. Buying penny stocks that are listed in the OTCBB and Pink Sheets can be extremely tricky due to the lack of information that is readily available to investors.

Understanding Penny Stocks

Penny stocks are highly speculative by nature. Usually, there are five reasons why a company might fall under the penny stock category.
1. High debt
2. Low revenue
3. Inability to turn revenue into profit
4. Product/Service outdated and phasing out
5. Distressed

If the following scenarios apply to the penny stocks you’re looking to buy then a value investing approach can be thrown out the window. To make a play on any of the stocks that fall under one of the five categories above it is going to be based heavily on speculation. This does not mean we can throw numbers and financials out the window, because that is not the case.

Golden Rule of Investing

The first rule of buying penny stocks is to invest in companies that you understand. If you do not understand how they earn revenue, what their business model is, and how they make a profit it can be very difficult to accurately analyze the business and make an informed investment decision.

Analyzing Penny Stocks

To begin analyzing penny stocks you first need to understand the situation a company is facing and why the market believes their value is so low. Is it because they have a really high debt to asset ratio or possibly due to having trouble generating profit? Looking for the underlying reason is always a good place to start when your’re seeking to purchase a penny stock.

Companies with High Debt

buying high debt penny stocks

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Lets say a company has a large sum of debt. This doesn’t necessarily mean that the company is in bad shape. To figure if it is or not dig a little deeper and figure out when and where the debt came from. Did the company just take out a loan so they could purchase more manufacturing/production equipment or expand their operations? If this is the case then there are a few things you can do to see if there is a good opportunity for investment.

In this situation I like to look at a few things.
1. What was their revenue, gross profit, and net income before they took on the debt?
2. What were their operating expenses, cost of goods sold, selling and administrative costs before the took on the debt?
3. What did the company do with the money they received?
4. What effect will this have on revenue, net income and gross profit?
*Note: You can also use other measurements such as EBIT, EBITDA, Earnings per share, and much more.

The best way to figure out where a company is going is to look at its history. For an example: lets say company X took on more debt to expand their operations. Company X took the money they received and purchased a new operating facility. They have now increased their operating capacity. All other things being equal what an intelligent investor must do is figure out how much this will increase their expenses against how much their revenue will increase, and ultimately determine the effect on the bottom line. This is no easy task, but by looking at their expenses prior to purchasing a new facility one can reasonably predict what additional expenses the company will incur. In addition to this, lets say the company has stated with their new operating facility they will be able to produce 2.5 times more widgets than they originally could produce operating out of only one facility.

For the sake of this example lets say the company has previously shown the ability to generate revenue. They had solid net income and operating income and now they can produce 2.5 times the number of units while only increasing their operating expenses by 75%. Of course these are fictitious numbers, but if you add everything up you could begin to see their is some potential here for an investment. At this point it would be wise to consider the opportunity cost of investing in this company. Opportunity cost is the cost incurred by the investor by not enjoying the benefit by the next best alternative investment. For instance say you want to choose an investment in a stock over a bond. Assuming the bond is risk free and pays 3.0% per annum, the opportunity cost of buying the stock over the bond would be not gaining the stable 3.0% per year on their investment.

This is just one example of why a company has a high amount of debt in comparison to its assets. There could be many other reasons and it’s important to carefully consider each. For instance, if we go back to 2008 when the market was in free fall; companies like AIG and General Motors had huge sums of debt. With an inability to pay this debt without government assistance and a great deal of restructuring their business models these companies would have bankrupt. In situations like this an investor must be extremely cautious when considering an investment. A company that is having trouble covering their short term liabilities could be in serious trouble.

Companies with Low Revenue

buying penny stocks with low revenue

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An investor must be very careful when they are looking to buy companies that are having trouble generating revenue. While there may be many reasons why a company is having trouble generating revenue most of the time it raises a large red flag. If the company needs to raise funding to expand and generate revenue through sheer volume there may be a potential investment opportunity at a very cheap price. However, I am always very wary of companies that are having trouble producing revenue because it usually suggests a flawed business model or a lack of demand for their products or services.

In the situation above, I take a step back to look at the company from the outside in and figure out exactly what the reason is. Penny Stocks that are on Pink Sheets do not have the same listing requirements as ones on major indexes so it may be difficult to come across the information you need. In this case I also like to stay away because in my opinion when I spend my hard earned money I’d like to know exactly what I’m buying.

Inability To Generate Profit

When a company is generating revenue and not generating profit a penny stock investor must understand the underlying reasons. It could be due to a one-time expense or lingering lawsuit or even a write-off of inventory. I know I keep saying this, but understanding what the company is facing is so important when buying penny stocks. Take a look at the company’s financials and see what’s happening and why they can’t generate profit. If you aren’t familiar with balance sheets, income statements and statements of cash flows it’s a great idea to take a crash course to understand what all the numbers mean, and how they effect the company’s performance. A great place to look for information is a company’s 10k. This is a yearly report where a company will break down everything they did or didn’t achieve for the past year. There is a lot you can learn within these documents including what the company’s plans are, as well as what portions of their business were profitable and what weren’t.

buying outdated product penny stocksCompanies with Outdated Product/Service

A company with a an outdated product or service can be an extremely tricky to analyze. A few things you may want to look out for is does the company has a succession plan in place to reestablish themselves in their industry? Over time new technologies come out and phase out old products. Some companies survive because they are prepared for this transition and some companies fail because they are not. It’s important to figure out if the company you’re looking at is ready for the transition.

buying distressed penny stocksDistressed Companies

A company in distress could be experiencing any one of the problems mentioned above or a combination of problems. Maybe there is a huge pending lawsuit causing the company to incur a loss. It could also be obsolete products or inventory. Again, its important to fully understand how the company operates and makes money before investing. While no one has a magic crystal ball to tell them what the future holds, understanding the reasons why a company is distressed could be the difference between making or losing a lot of money. My favorite example of a company in distress (that would have been a great investment) was McDonald’s in the early 2000’s. Somehow, a chicken head made it into a box of McNuggets and when investors caught wind of this they simply overreacted. People started selling off shares and the company’s stock price dropped swiftly to almost $10.00 a share. McDonald’s was a gigantic brand and an American staple at this point in time. The company wasn’t losing money, the bad publicity didn’t slash their net income in half and they definitely had more than enough cash to withstand any potential lawsuit. In this instance, McDonald’s would have been a great investment, because shortly after the bad publicity died down the company quickly crept back up to its original share price.

While the instance above was a rare case, there are thousands of random events that happen each year that affect the price of shares. When this happens there could be a great opportunity to buy stock. However, it’s impossible to know if you can’t properly analyze the position the company is currently in.

Buying Penny Stocks

Once you have looked at a company, analyzed it and figured out if it is right for you; it’s now time to actually purchase the company. However, trading penny stocks can be another game in itself. The key here is to determine a value you are willing to pay that is inline with the research you conducted. A great company with a promising future may still turn out to be a disaster investment if the company is priced too high. The good news is penny stocks are cheap! This doesn’t mean spend frivolously, but usually you will find some very affordable companies to buy. Before buying penny stocks, it is a good idea to consider if the share price is too high by looking at other companies in the industry. One measurement is to look at the companies P/E ratio (price divided by earnings) versus its competitors. If you are pursuing a value investing approach, is the penny stock you’re interested in buying intrinsically more valuable than its competition’s share price?

For more penny stock trading tips and advice click here.

Closing Thoughts

Be sure to take enough time to understand what financials mean, how to use them, what they represent, and most importantly understand how the business makes money. When you offer up your money as an investment, you are basically saying you believe in a company so much so you would like to own a portion of the business and share in its successes and its failures. While this may seem really trivial, I often meet people who forget about this when investing in the stock market. The last question you should ask yourself is: Is this a business I’d really like to own?

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