An Investor's Guide: What are Penny Stocks?

[cmtoc_table_of_contents]

What Are Penny Stocks?

Penny stocks are stocks with lower market capitalisation relative to the other companies; primarily, these are new companies in the publicly traded market. Alternatively, penny stocks are also identified as micro-cap stocks and nano-cap stocks in the US market.

In order to promote healthy market conditions and protecting investor’s interest, trading in penny stocks is highly monitored by ASIC. In this regard, ASIC had summoned companies with unfair trade practices in the past.

Meanwhile, investors looking for high growth companies often end up investing in penny stocks, since the market capitalisation of penny stocks is relatively lower to other small cap companies. Hence, the possibility of any of the penny stocks doubling its market value in a short period of time is likely against the companies, who have relatively larger market capitalisation.

Also, high growth attributes of a business depend upon the market environment, in which it is plying its trade. Also, competitive advantages, market competition & product differentiation plays an important role. Disruptive technologies and structural changes in the business environment could possibly lead to better opportunities for companies in a similar space.

As an example, we can look at the metals & mining sector in Australia. Lately, the animal spirit in the sector have been propelling investments, and a lot of development has taken place in the past two-three years. As a result of this, mining services companies have also gained traction, and revenue of these ancillary services companies to mining business has gone up.

Ausdrill Limited (ASX: ASL) a mining services company, recently on 29 August 2019, released its full-year results closed 30 June 2019. Interestingly, the revenue of the company witnessed a growth of 89.1% over the previous year attributing to escalated business opportunities.

ASL’s Mining Services, Source: Company’s Report

How to Buy Penny Stocks?

Penny stocks are bought and sold as any other stocks. You would need to work with your broker to get your trades booked. In case, if you are using any trading platform to trade on financial investments, the same trading platform could be used to trade in penny stocks as well.

Investors could also check the latest bid/ask for the stock, as it provides an idea as to what extent the price is going to be during the transaction.

Penny Stocks: An Introduction
Throwing light on Penny Stocks

A company with $500 million in market capitalisation could have its share price below one dollar as well. It depends upon the total number of shares issued in the market, companies with large market capitalisation and an even larger number of shares issued in the market relative to its market capitalisation could be priced lower than one dollar.

Consider a company with $200 million shares outstanding at a market capitalisation of $100 million. This equates to a share price of $0.05 per share. Now, if the same company had $100 million outstanding shares, the value of the stock would be $1 at a market cap of $100 million. The market capitalisation of the stock equates to number shares outstanding times the market price of the stock.

Fundamentals

In this regard, there are a lot of questions to ask. Some of the meaningful questions that could be asked are:

  • What is the business about?
  • Is there any upside to the business considering the current market condition?
  • How is the management utilising the capital? Are they being overpaid?
  • What are the competitive advantages, and who are the competitors?
  • Does the business have any disruptive technology?

Besides these, the focus could be laid upon price-to-book ratios. Whether the business has prospects to become profitable in the near future; and if the possibility exists, there could be a substantial upside. Further, business performance should be assessed thoroughly, which could enlighten the possible risks in the business. Substantial information could be acquired from the annual report, periodic announcements, and prospectus when the company is new.

Volume

Most of the investors refrain from investing in penny stocks. As a result, these stocks often have lower volumes and less liquidity. Investors must look out for stocks having greater volumes, which could help while liquidating any positions. Stocks trading with lesser volumes could give hard time while matching your trade order, and this could take longer than the expected time period.

Earnings Visibility

Companies with visible earnings potential should be favoured to others. Sometimes, in penny stocks, this could become a problem because most of these companies tend to be in a developing stage. However, the efforts by the company to achieve commercialisation of its business products should not be ignored as well, when the company is in the development phase.

Earning potential could be judged by the type of business the company is operating. Who are its main competitors, and most importantly, what are the attributes that distinguish this company to its competitors?

Value Potential

Investors should judge the potential value in the business. The business potential could be assessed through an in-depth review of the company. These include the macro factors as well as company-specific fundamentals.

Cannabis Industry provides a real time example in this case. There is no denying why the investment in the cannabis stocks have skyrocketed given the medicinal benefits of the drug. As a result of this cannabis boom, there exists a possibility of cannabis-based medicines acquiring the current market share of the drugs being used for similar treatment, which could lead towards potential revenue loss for the existing treatment due to the emergence of medicinal cannabis drugs.

Capital Management

Effective capital management often leads to better shareholder returns, and as penny stocks are in the developing stage, there is a substantial need for capital to pursue day-to-day business activities. Besides, the capital management prowess of the company’s board is tested at times.

Investors must review the capabilities and credentials of the company’s board. Capital raising decisions should be assessed by the investors. If the company is raising capital through debt; it should be checked whether the current cash flows levels would meet debt service payment, and ultimately, the repayment of debt principal.

Meanwhile, the initiatives by the company to cut its costs would help to optimise cash burning in daily activities. Companies raising capital through equity financing often leads to more dilution of the share capital, resulting in lower prices.

Joining AGM or Annual General Meeting

If possible, one should take part in the Annual General Meeting of the company, which could provide one with the answers to many unanswered questions. This meeting is specifically provisioned for the shareholders to put their perspectives across the board. Also, being a shareholder means, one has an ownership stake in the company, and it is an investor’s right to question the management and board of the company.

Recent News

Daily Discussion of ASX Shares and Market Action.