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Everyone wants to make money without spending a lot of money, which is why penny stocks have always been popular. Of course, there are plenty of stories of a friend going in on a penny stock and selling for such a profit that we kick ourselves for not listening to the suggestion to go all in. And then again, there are plenty of penny stocks that go nowhere.
How do you find that diamond in the rough? Here are some tips on how to find good penny stock.
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What is penny stock?
Penny stocks are stocks trading at a low share price, often for as low as $1 or even less than $1. As per the Securities and Exchange Commission, penny stocks are the stocks that are selling below $5 a share. It can debut in the stock market through an IPO like any other stock.
Since the stock price is low, it is attractive for investors keen on buying the shares and watching them grow tenfold or twelvefold in the future. However, before dabbling into penny stocks, you should note several key factors that affect how the stocks trade and have a complete understanding of the risks associated with the investment.
Certain penny stocks are good stocks that have become devalued for some reason, but they have the potential to rebound, while many others have a slight chance of growth and could become a money pit. Hence, the stock price does not reflect the company's quality, so you need to consider different factors when looking for the best penny stocks.
Investors who buy penny stocks that trade on the over-the-counter (OTC) market tend to lose money. Still, if they buy well-known companies on the major exchanges, it will improve their chances of success since they are serious companies with strong fundamentals and a solid business model. Even with the case of penny stocks, if the companies have their stocks listed on major U.S. exchanges, it is a sign that the firms have passed a certain level of regulatory vetting and produced enough financial disclosures to be allowed a listing on the exchanges. It is a sign that the company has a healthy standing and a chance to turn the business prospects around. You must conduct due diligence before investing your money.
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What to look for when investing in penny stocks
Company valuation and share price
Huge mistake investors make is that they consider penny stocks the most affordable and believe that they have a solid chance of getting solid returns for their buck. Hence, they buy thousands of shares with the hope of making big money. It is not all wrong, but one must consider it rationally. An investment of $1,000 in a company that trades at $0.08 will allow you to own 12,500 shares, while in another company, you will only be able to buy 12 shares if they are trading at $80.
One must check the number of shares outstanding in a company. Even if two companies have the same fundamentals, with the only exception being the number of shares outstanding, you will see a massive difference in how the shares trade. The company valuation or the company's market capitalization is the number of shares outstanding multiplied by the share price. If two companies have a $100 million valuation, the share price and shares outstanding will still vary.
If you decide to buy the shares solely based on the share price, you could be making a mistake. Do not assume that the quality of the firm trading at $100 is higher than the one trading at $.10. It may not be the case. The difference could be due to the shares outstanding, and the firm trading at $.10 may have 1,00,00,00,000 shares outstanding while the one trading at $100 could only have 10,00,000 shares outstanding. Therefore, always consider the number of shares available when looking at penny stocks.
Dilution
When looking for good penny stocks, understand the impact of dilution. When the number of shares in a company balloons out of control due to stock splits or employee stock options, it will dilute. Whenever a company issues shares to raise capital, it will dilute investors' ownership percentage, and several companies follow this route.
If a company issues an additional 100,000,000 shares to raise capital, then it is evident that the share price will fall from the current level. The business has not changed, and the market cap hasn’t changed either, but the number of shares will lead the price to drop. It helps to choose a company with a solid grasp of the share structure because constant dilution will erode the value of the owners' shares.
The type of company
Do not make the mistake of buying anything that is currently hot. It is the one talked about in the news, your colleagues mention it, or your parents recommend you to buy some. However, by the time you hear about it, it has gained high popularity and is on everyone’s radar. The trade is mature, heavily overpriced, and very crowded. The next move for the hot industry is usually the downside. Hence, the move from hot to former hot will result in a huge dip and a major collapse for penny stocks. So always buy what you know. If you know the EV industry, you will have an advantage in trading EV stocks. If you work in the gold sector, you can pick the right gold stocks. Or just buy what makes the most sense to you based on the company fundamentals and reports.
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Verify the exchange
You can find some penny stocks on major stock exchanges like NYSE and NASDAQ but not all meet the listing requirements. Many others can be found on pink sheets and over-the-counter bulletin boards, which are high risk and show a chance of price manipulation.
Check the volume
Stock traders believe that volume is an integral part of their trading strategies. The volume will show an absolute significance about the stocks. Hence, always observe the volume and consider how it affects the price volatility. Consider the volume of the stock you want to buy based on the monthly trading volume and the average daily. If the stock has high volume, it is a good buy and if the volume is very low, avoid the stock. You do not want to end up with 1,000 shares if only 50 are traded a month. When day trading penny stocks, consider the volume and if it is abnormally high or low, identify the reason behind the same before investing.
Company fundamentals
Irrespective of the type of stock you are keen on buying, large-cap, small-cap, or micro-cap, it is essential to understand the company's fundamentals. Go through the company's financials and read through the income statement and balance sheet. Understand how the company makes money, how much debt it owes, and how many assets it owns. You must also check the revenue and profit for the past three years before shortlisting the stock.
Identify the investment horizon
Keep in mind that it will take time for the stocks to break out with penny stock investing. The stock can't double in value in a month. Consider your investment horizon before making a decision. If you plan to hold the shares for the short term and need liquidity in a couple of months, trading penny stocks may not suit you.
Consider your risk appetite
Penny stocks are considered risky, and you should have a high-risk appetite when you invest in them. There is a chance of making solid money and an equal chance of losing all your money. Beginners must identify the risk tolerance before taking a plunge.
Avoid pump and dump stocks
Many OTC stocks are marketed based on false statements to mislead investors. Pump and dump is a security fraud that will inflate the price artificially and mislead the company statements to sell the cheap stock at a higher price. It could be a scam and is common with micro caps and cryptocurrencies. They guarantee high returns, but in reality, nobody can guarantee returns on stock market investment. Volatility is a part of the market, and whether you buy top growth stocks or penny stocks, will affect the investment. Hence, avoid investing in the pump and dump stocks.
Double-check their claims
Penny stock promoters will claim that their company is about to make big moves in the industry, like getting an FDA approval for their drug or accessing a new gold mine, exponentially improving the company's earnings. Such claims are the bait to get you to invest. So, make sure that you find the right information and verify it from legitimate sources before you bet your money.
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How to pick a winner
You will find many companies that trade with share prices lower than a dollar, and they also have small market capitalizations. However, it doesn’t always have to be the case. You must understand the fundamentals of the company before investing. Understand if the company often relies on issuing new shares to raise capital and if the company is profitable or will be able to turn a profit in the near future. When you do the homework, you will find the right stocks for investment.
Another factor to consider is that some sectors are more common for picking stocks that trade under a dollar. The mining sector is popular for penny stocks. Additionally, if you invest to generate passive income, you need to choose those that pay regular dividends. Several companies pay consistent dividends to investors.
The bottom line
Many traders look at penny stocks and ignore the underlying fundamentals like the outstanding shares or the history of a stock split. Hence, one must examine the company’s fundamentals and understand the business before investing in penny stock. Keep an eye on the share structure and understand that low-priced stocks are not always winners. They are not suitable for everyone, but they do have a lot of great attributes. It is possible to turn a small investment into a considerable amount of money, but they can easily wipe those dollars out as well.
But it is possible to avoid the losses that investors make when trading penny stocks. If you can save time and money by not buying the wrong stocks at the wrong prices, you can make money. Find the stocks using a stock screener, which will help you understand the best investments and learn more about investing. If you want stocks trading at $5 or less in the metals industry, you simply need to set the screener to show only those results. Online brokerages also have stock screeners that help you filter and pick the right small-cap and micro-cap stocks in the price range you seek. You can open a brokerage account with Robinhood to make commission-free trades. However, nothing will beat research regarding the best stock picks.
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- Averaged Stock Pick Return over 593% (vs. 165% for the S&P)
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Writer
Vandita Jadeja is a financial writer and editorial assistant at Joywallet. She loves to read and write about money and brings 7 years of experience from the financial industry. She loves coffee, mountains and sunsets.
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