Introducing Penny Stock Investing
Penny stock investing is an exhilarating investment strategy that offers many wonderful opportunities to strike rich. However, it also comes with inherent risks that you won’t be finding investing in other assets.p
Therefore, an investor must develop a unique skill set, specific only to penny stocks, if they wish to be successful. These skills include an ability to identify excellent businesses trading at a discount, the fortitude to overcome natural emotions like fear and greed, and the uncanny ability to sit patiently while everyone else is buying.
Fortunately, it isn’t as hard as you might think. In this how to invest in penny stocks beginners guide, we will teach you how penny stock investing can be a profitable investment experience and offer a few ways to effectively invest in penny stock without taking on much risk. After all, the goal is to make more than you put in, so why not make one of the most lucrative opportunities in the stock market a legitimate piece of your portfolio?
What is a Penny Stock?
According to the Securities Exchange Commission (SEC), a penny stock is defined as any publicly traded company trading under $5.00 per share or a market capitalization of $300 million.
Investors who are most likely to be drawn to these kinds of investments are those with long investment horizons and are comfortable with assets that possess greater uncertainty than more established companies like large-cap stocks. That is because penny stocks are often considered riskier investments due to the lack of financial information available, higher volatility, and greater susceptibility to crashes.
That being said, the long-term performance of the penny stocks trade largely depends on the individual fundamentals of the business and the management team in place. Therefore, it is more important for penny stock investors to determine the individual performance of a business, rather than to generalize the asset class as a whole.
Since the goal with penny stocks is to generate superior returns compared to other asset classes, then one must only focus on the stocks with the best chance of success over an extended period of time.
All-in-all, penny stocks can be a great way to help bolster your returns if you take the time to properly pick the diamonds from the rough.
Why are Penny Stocks so Cheap?
Penny stocks can be cheap for a variety of reasons, however, the most common reasons are that the stock is still in its early stages as a business, the company hasn’t produced any cash flows thus making it more difficult to value, or that the industry it operates in has limited value potential.
No matter what the reason is for its current market cap valuation, an investor must separate what the business is worth from what the stock is trading at. That’s because the price of the stock and the worth of the business are two completely different things.
Though the stock price often reflects the intrinsic value of the business over the long run, in the short run, there can be a great discrepancy between these two valuation metrics. As such, an investor must be able to determine what the business is fundamentally worth and pay close attention to where the stock is trading to ensure that they are not overpaying for a business.
Under these circumstances, not all penny stocks are cheap. It ultimately depends on the value they are creating for the world, the cash they generate, and the investments they make to effectively grow.
A good business will do so in a way that maximizes its abilities within the limitations of its industry. A great business will change the way the industry operates and ensure that no competitor stands a chance against them.
We aim to find those businesses because one day their potential will be realized and their massive market cap will reflect that. For now, it is best to find solid businesses that are producing cash flows and to avoid stocks that appear cheap but are actually fundamentally flawed.
Are Trading Penny Stocks Risky?
Yes, like any investment opportunity out there, penny stocks bear risk. However, unlike what most investors believe, the biggest risks associated with penny stocks are not the price volatility, but rather the fundamentals of the business.
Given that most penny stocks tend to be in the early stages of the business cycle as is the case with most Cannabis penny stock companies and Psychedelic penny stock companies, it’s unlikely that they have accumulated enough cash flow to operate sustainably on their own. As such, penny stocks are somewhat at the mercy of the markets, meaning that when times are good, the stock price tends to rise, and when times are tough, the stock price will likely fall, and fall hard.
It’s only during these tougher economic periods that investors truly understand what a business is made of. If a penny stock company has built multiple recurring revenue streams, has ample funding over the next two years, and is growing across multiple financial metrics, then the business is likely to be much less risky than a penny stock, or a larger company for that matter, with declining revenues or no sales at all, and boatloads of debt.
Ultimately it’s the financial state and economics of a business that determine how risky a stock is, not the size of the business. That being said, due to a lack of liquidity in these markets, it’s often the case that penny stocks are less predictable in the short run, meaning that the stock price can fluctuate more frequently.
Though volatility may not be an indication of real business risk, it can still be quite difficult for investors to stomach these fluctuations. Therefore, if you have a shorter time horizon or are seeking greater price stability, it’s probably best that you avoid penny stocks altogether and focus on large caps instead.
All-in-all, penny stocks can be considered riskier than large caps simply because they have less capital to work with, but not because their stock price swings up and down all the time. Regardless of market cap size, if you focus on finding stocks with strong business fundamentals, a strong financial history, and past performance and buy them at a reasonable price, you will likely eliminate much of the risk associated with investing in stocks altogether.
Why are Penny Stocks Volatile?
Penny stocks are more volatile than mid-cap and large-cap stocks because they have less liquidity flowing in their markets. According to Investopedia, liquidity is the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price.
In other words, if there are plenty of buyers and sellers in a given market, then it is likely that someone trading a specific stock will more often than not find someone on the other end to close out the deal.
This isn’t always the case for penny stocks. Since there are fewer buyers and sellers of these assets, you may run into periods where it is difficult to sell or buy into a business because no one wants to make an offer at that specific price.
As such, the stock price can sometimes fluctuate massively to meet the demands of the buyers and sellers.
This leads to less price stability than other assets but is not a direct indicator of business risk.
For example, if you are holding a penny stock that publishes poor earnings results in a quarter, it is likely some investors will get spooked and try to sell the stock all at once.
However, since the penny stock buyers are also receiving this bad news, they may cause them to hesitate from buying the stock unless it is at a cheap enough discount.
This results in an oversupply of sellers and not enough buyers, meaning that the stock price will likely tank until the number of buyers and sellers levels out.
While this buying and selling pressure happens with assets of all sizes, penny stocks will probably experience these swings more dramatically than a bigger business with more liquidity.
Therefore, it’s important to pay attention to the liquidity of penny stocks by keeping track of their total shares outstanding, and the average daily and monthly trading volumes.
This will ensure that you are not overwhelmed if the stock price begins to fluctuate massively.
Can You Get Rich Off Penny Stocks?
In short, you can get rich investing in penny stocks, but it takes considerable luck and skill to do so.
Instead, the more important question to ask is how to never lose money trading penny stocks.
The reality is that over 90% of penny stocks fail and on average, penny stocks have produced a negative annual return of 24%, according to Quantified Strategies. With numbers like these, it can be discouraging for investors to invest in penny stocks at all, but there are a few ways to reduce these poor outcomes significantly.
As we mentioned before, the key to successful investing is to focus on buying wonderful businesses at discounted prices.
If you do so effectively, you will eliminate a lot of your downside risk while also increasing your likelihood of making money along the way.
Since most penny stock businesses fail, you must be willing to say no to 90% of the opportunities out there and hone in on the few penny stocks that have a legitimate shot.
By doing so, you are more likely to reap the incredible upside potential that some penny stocks have to offer without sacrificing your capital and sanity along the way.
To expand on this process further, in the next section, we will dive into a few ways you can avoid costly mistakes by properly evaluating penny stocks.
Though nothing is guaranteed in the stock market, these rules are sure to help improve your likelihood of success in these markets.
To learn more about how to make money with penny stocks, check out our article here.
How to Evaluate Penny Stocks
Given the long-term uncertainty of most penny stocks, an investor must conduct thorough due diligence if they wish to even stand a chance in these markets.
Therefore, it is encouraged that you spend significant time diving into the financial statements and fundamentals of penny stocks, even more so than you would with larger companies.
Ultimately, you want to be sure that this investment will be around 10 to 20 years from now and that it will eventually result in a profitable endeavor.
To better guarantee these results, here are four rules to consider when investing in penny stocks.
Rule #1: Revenues are Great, Profits are Better
First and foremost, only invest in businesses that are making money by way of their products and services.
Although most penny stocks are not profitable yet because they are reinvesting all their cash back into the business, we still want to ensure that they have built a product that customers find valuable and are willing to buy more of in the future.
The more products and services they offer like these, the better.
Cash flows are the lifeblood of a company and if a business depends on external capital to stay afloat, it’s unlikely that it will survive in the event that funding dries up and investors shift their focus to safer bets.
However, if a business can sustain itself organically, rather than through capital investment or debt, this demonstrates its ability to effectively grow in the long run regardless of the economic conditions at the time.
We always want to ensure that the penny stocks we invest in are consistently making money and doing things to cut costs when necessary.
The best way to achieve this is by investing in businesses that have access to a large market where capital expenditures and upfront costs are at a minimum.
In doing so, the business will retain more of its capital (demonstrated by wide profit margins), meaning that it can more freely strengthen its competitive advantage without jeopardizing the company at large.
Overall, the more years a company can demonstrate its ability to grow revenues and sustain profitability, the better idea we will have about how the stock might perform in the long run.
Rule #2: Do You Understand the Business?
Although it may be exciting to invest in the next great space company or artificial intelligence stock, the reality is that it is very unlikely that most of us truly understand the dynamics at play in these industries.
Sure, you could take the time to familiarize yourself with a company and how it operates, and we encourage you to do so, but it’s ultimately quite difficult to know the inner workings of these complex businesses unless you have worked in the industry or are a consumer of these products.
Therefore it’s better to stick with businesses you can understand without much effort and to focus on a few stocks that you are confident will be around for the long haul.
If your goal is to sleep peacefully at night knowing that your money is in good hands, one of the most effective ways to do so is by only investing in stocks that you could easily explain to a kindergartner.
If this is too difficult, then it’s probably best to pass on that stock and move on to the next one. In the case of investing, ignorance isn’t bliss.
No matter the business, try to learn as much as possible about a company and realize that there will always be some uncertainty at play.
After all, our money is important and we don’t want to leave these key decisions up to speculation.
Rule #3: Bet on the Jockey’s
Investing in businesses with a proven and talented management team is one of the most critical factors when investing in penny stocks.
That’s because much of a company’s foundation has yet to be established, therefore it’s crucial that those in charge make the right decisions to properly set the business up for success in the long run.
The ideal candidate for CEO is someone who is open and transparent about everything that happens within the company.
Not only that, but you want someone who is comfortable with making the tough decisions like where capital should be spent and what can be done to reduce the business’s operational costs.
To gauge these two fundamental characteristics, read any materials where the CEO openly addresses the company’s shareholders.
For example, if in their annual letter to shareholders, they openly admit to mistakes, don’t over-promise, and outline clear long-term objectives for the business, then this is a good indication that they are right for the job.
You can take this evaluation process a step further by also measuring the success of their capital allocation abilities.
To do so, simply calculate the company’s return on equity (ROE) by dividing its net income by its total shareholders’ equity.
If this number consistently exceeds 10% and is growing, this is a great sign that your CEO knows what they are doing and is making the right decisions about where the company’s money should be spent.
Though these are only a few of the many factors that you should consider when evaluating a CEO, it’s a good starting point and one that should be implemented into every investment decision.
If you want to take it a step further, we highly recommend that you read these three books:
- Investing Between the Lines by L.J. Rittenhouse
- The Outsiders by William Thorndike
- Good to Great by Jim Collins
After reading these books, use the many lessons they teach to better understand what makes an excellent leader and compare it to every penny stock’s CEO before investing.
Rule #4: Buy at a Margin of Safety
Lastly, you only want to invest in a stock when it is trading below what it is worth.
As we mentioned before, the value of a stock and the stock price are not the same things.
Therefore, we only want to take advantage of opportunities when the stock price is trading for cheap and well below the underlying value of the business.
In doing so, you naturally create a margin of safety by eliminating downside risk and protecting yourself from any inherent biases you might have towards a company.
This is vital because every stock will ultimately reach its true intrinsic value in the long run and if you overpay, you will likely generate poor returns on your investment.
To determine whether or not a stock is cheap, compare it against other stocks in the same industry and use financial metrics like the P/E, P/BV, and EV/EBITDA ratios to see which of them is trading at the lowest multiples.
If the penny stock is trading below the multiples of other stocks and below the industry average, then it is possible that the business is on sale at a discount.
That being said, there are other effective ways to value a company such as a Discounted Cash Flow model which forecasts a company’s cash flows into the future and discounts it back to its present value by using a pre-determined discount rate.
If you’re comfortable with building these models, then it’s recommended you use this method instead because it eliminates the emotional factors at play (related to the stock price) when valuing a stock.
All-in-all it does not require much to know whether a stock is undervalued or not. The key is to focus on those stocks that are so obviously cheap that it requires very little thought at all.
That way you can know for sure that your chances of losing are very limited and that the potential for massive gains is high.
When investing, always remember these three words:
MARGIN OF SAFETY!
Where to buy penny stocks
Before beginning to learn how to buy penny stocks, you first need to know where to buy penny stocks.
To begin, set up a brokerage account through your bank or an online broker.
According to Investopedia, a brokerage account is an arrangement in which an investor deposits money with a licensed brokerage firm, which places trades on behalf of the customer.
In other words, a broker acts as the middleman who seeks out another investor looking to sell their shares of stock.
While in today’s world, filled with technological advancements, it may feel that there is always someone looking to buy or sell, it is important to remember that there must always be both a buyer and a seller for a trade to be successfully executed.
Oftentimes, you may never run into this issue, however, due to the size of penny stocks, they are generally less liquid than larger stocks meaning that fewer transactions occur daily.
Keep this in mind if you are looking to add a significant amount of capital to a penny stock, as you will need to be strategic about how you execute your order.
How do stock brokerages work?
For their efforts, brokerage firms often charge a commission fee with every transaction made.
However, in recent years, these fees have significantly decreased due to improvements in transaction efficiency, with many brokerages even offering zero commission fee trades.
While this certainly sounds enticing, one should consider which brokerages offer the greatest value depending on what you are trying to accomplish as an investor.
For example, an investor looking to actively trade should consider brokerages such as TD Ameritrade, or Lightspeed Trading because they offer valuable trading tools and low commission fees on every transaction.
Alternatively, Questrade and Wealthsimple are excellent platforms for the average retail investor regardless of whether you are making trades daily, monthly, or yearly.
Another thing to consider is that not all stock brokerages offer penny stock trading because of the exchange’s unique requirements for volume, share price and other considerations like revenue.
Once again, due to their size, many penny stocks do not fit the criteria necessary for trading on major stock exchanges like the Nasdaq or New York Stock Exchange.
Instead, most penny stocks trade over-the-counter (OTC) or on smaller exchanges like the TSX.V or the Neo exchange.
Therefore, if you are looking to invest in penny stocks, here are three brokerages that offer a large variety of penny stocks to choose from
- Interactive Brokers
- Trade Station
How to Find Penny Stocks before they Explode
There are thousands of penny stocks out there, so how do you know which ones to choose?
The easiest way to find penny stocks before they explode is to use a filter of sorts to help eliminate any unwanted penny stocks.
Fortunately, there are many cheap or free stock screeners out there that will help find only the best penny stocks to choose from.
One of our favorite stock screeners is Macrotrends.com.
As we discussed before, we only want to consider businesses that are generating revenues, investing capital effectively, and possessing little to no debt on their balance sheet.
By inserting only three filters that meet these investment criteria, we have whittled our way down from 6154 to just 106 stocks.
Though there is still a lot more due diligence that is required before pulling the trigger on an investment, using screeners like this one will help get rid of the fluff quickly and inefficiently, without much hassle.
Take some time to mess around with these filters on your own so that you can find an investment strategy that works best for you.
After you do so, the final step is to use the four rules for evaluating penny stocks from before and determine which of the stocks you have found best meets this criterion.
If you find one that you can easily understand and is impressive across multiple counts, then you may have found a diamond in the rough and the next great penny stock.
To learn more about how to buy penny stocks and where to find them, check out our Beginners Guide to Buying Penny Stocks, here.
How Much Should You Invest in Penny Stocks?
As a beginner investor, it is probably best that you invest very little in penny stocks.
Given their volatility and the higher degree of economic uncertainty that exists in most of these businesses, investing in penny stocks can be very risky if you are not familiar with the market.
It’s a good idea to start by investing in larger, more predictable stocks or ETFs to ensure that your money is secure, and then maybe you can work your way down toward penny stocks.
With that being said, as you take time to improve your investing skills and understanding of the different kinds of businesses out there, it’s possible that you can allocate more and more of your investment portfolio toward penny stocks.
Ultimately, there is no perfect answer for how much you should invest in penny stocks.
Instead, focus on finding an appropriate amount of capital that is suitable for meeting your personal investment needs and use that as your benchmark.
All-in-all, you never want to put yourself in a position where investing in a stock is too much to handle.
If you do, it’s best to reduce some of your exposure so that you are in a clearer mental state when managing your money.
Remember, investing is an emotional game, and those who find the most success along this journey, are the investors that focus on protecting their downside and conquering their emotions.
If you can do both, you are sure to reap the benefits of a balanced and well-thought-out investment portfolio.
How to make money with penny stocks
So you’re now familiar with the buying process, but the question on everyone’s mind is: How to make money with penny stocks?
The stock market is often considered a gambling parlor due to the high degree of uncertainty and risk involved when making investment decisions.
For example, in 2021, financial markets experienced their best year ever with many stocks achieving all-time highs and record profits.
Yet only halfway through 2022, we are experiencing the worst start to a year in over 50 years.
This notion is further accentuated in the penny stock market due to the size, experience, and diversity of stocks available to investors.
While the change of narrative between these two years is startling, it is not as uncommon as one might think.
Therefore as investors, is it even worthwhile to invest in the stock market if these violent fluctuations happen so frequently?
Furthermore, is it even possible to make money on penny stocks if they are so risky?
Well, it ultimately depends on the kind of investor you want to be.
The difference between speculation and investing
Ben Graham, the father of value investing made the distinction between speculation and investing in his book, The Intelligent Investor:
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
In modern terms, investing exists only when the investor has a high degree of certainty that their investment will return their initial capital, plus additional earnings in the future.
This is achieved through a proper analysis of the business in which the investor is able to easily understand its operations and knows the value that it provides to society.
Well if that is the case for investing, speculation or gambling entails any form of investment whereby the speculator seeks to capture profit through short-term bets in which they expect the stock price to rise merely on the basis of a trend or near-term tailwind, with little analysis on the stock actually conducted.
Another way of thinking about it is that an investor should view themselves as a business owner, as much if not more than they consider themselves an investor.
To help understand the importance of this, ask yourself this question:
If I didn’t have the choice to sell, would I be willing to hold this stock, or own this business for 10 or more years?
If you can comfortably say yes, then you are already on the right track to being a successful investor.
This assessment is even more necessary for penny stock investors because a majority of them are bound to fail.
Fortunately for us, there is a way to greatly improve your odds and make money on penny stocks as an investor.
Three risks to consider when investing in penny stocks
Before we begin picking the winners, we should first consider some risks involved in this market. Penny stocks are often considered riskier than most assets, and for good reason.
They are small, unproven, and often young businesses that still have a long way to go before reaching their peak. But that doesn’t mean they should be dismissed as an excellent investment.
With the right strategy and mindset, anyone can make money on penny stocks.
1. The companies are young and untested
Given the size of the business, most penny stocks are young companies that likely IPO’d recently within 5 years.
As such, stakeholders have yet to face much adversity whether that be a recession, financial scandal, or a major shareholder selling off a large position.
Furthermore, the company may be facing competitors that are significantly larger in size and presence, thus they must find a way to create a competitive advantage and carve out their own niche in the market.
The more time an investor has to evaluate a business and how it performs, the better understanding they will have of how it behaves during unfavorable periods.
According to Investopedia, illiquidity happens when a security cannot easily and quickly be sold or exchanged for cash without a substantial loss in value occurring.
As such, penny stocks are inherently illiquid due to their size and the number of investors trading in the space.
Given this unfavorable state, it is important to remember that you may not be able to exit your position at the desired price point if there are a limited number of buyers in the market.
To mitigate this, a long-term strategy is effective because it allows you to ignore the daily price fluctuations that tend to occur; not to mention that as the business grows, so too will the number of investors in the market, meaning that there will be additional liquidity as well.
3. Lack of business information
Similar to the first risk, penny stocks are often new companies meaning that they have little financial performance to show for it.
With barely any financial information to support the company’s claims, investors are forced to rely on the integrity of the management team and the core strength of the business model.
Rather than trying to invest in penny stocks like these with no financial performance, look for stocks with a 3 to 5-year track record so that you gain a realistic perspective about how the business is doing.
Investing in penny stocks can be risky without the right strategy.
However, if you take the time to do proper due diligence and focus only on those businesses with favorable economics and fundamentals, you may set yourself up for greater returns over the long run.
Therefore, with the right mindset and work ethic, you will find great companies that will help you grow your assets at a faster rate than they otherwise would.
With that being said, if you are a serious investor and want to achieve financial freedom faster, penny stock investing is a strategy that everyone should consider.