How to Make Money with Penny Stocks – 5Learning how to make money with penny stocks can be the difference between an early retirement and working for the rest of your life.
The catch is knowing which penny stocks are likely to boom and which ones are bound to bust.
What are Penny Stocks
According to Investopedia, a penny stock is most often described as any stock that is trading for less than $5 per share.
In addition, penny stocks are considered to have a market capitalization of less than $300 million.
Due to their size, penny stocks experience higher than average volatility compared to bigger companies because there are fewer active participants (investors) trading in these markets.
What this means for shareholders, is that even one high net worth investor is capable of drastically changing the price of a penny stock if they were to buy or sell a large portion of its shares.
Keep this in mind when trading penny stocks because those with the least liquidity are the most susceptible to price fluctuations like these.
This is because most of them do not meet the size requirements, financial health, trading volume, or a variety of other criteria set up by the larger exchanges.
While this rarely affects the small retail investor, you may run into problems when trading higher volumes of money because there are not enough market makers in the market.
For these reasons, penny stocks are dubbed to be riskier than your average stock and are more speculative than other investment strategies.
While true to some extent, if an investor conducts a thorough analysis of the business and its industry, they gain a better understanding of how the stock will perform, which improves their chances of success when investing in this market.
How to buy penny stocks
As mentioned above, penny stocks generally do not trade on larger and more popular exchanges because of their size, therefore it can sometimes be difficult to purchase a specific penny stock if you don’t have access to that exchange.
To remedy this, look for stock brokerages that encourage penny stock trading and offer a variety of stock exchanges for investors to trade on.
We would recommend that when looking for a brokerage to store your money in, to compare the associated fees that they charge for each trade and whether they are offering additional tools for finding the best penny stocks.
For more information, check out our “How to Buy Penny Stocks” article which provides an in-depth explanation of stock brokerages and where to find penny stocks.
How to make money with penny stocks
Due to its speculative nature, penny stock investing is commonly believed to be the equivalent of gambling in a casino.
For context, although it is possible for a penny stock to turn into a 100 bagger, making you significantly richer, it is just as likely for it to crash and burn leaving you with nothing.
For the average investor, this may be true, but what if there was a way to significantly increase your odds of success while reducing your risk at the same time?
To do so, the first step requires an investor to forget the common misconception that the price of the stock accurately reflects the value of the business.
Instead, a business’s stock price is merely a reflection of how investors are behaving in the market at that time, and whether they are acting rationally or fanatically when making investment decisions.
In a rational world without emotions, it is expected that the stock price grows in unison with the operational growth of the business.
While this is ideal, what we actually experience are cycles of fear and greed whereby investors buy when everything is rising, and sell the moment the story changes for the worse.
Legendary investor Warren Buffett describes this manic behavior perfectly, in his 1987 letter to Berkshire Hathaway Shareholders using Ben Graham’s infamous character, Mr. Market:
“Imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. […] At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.”
As Mr. Buffett explains, the stock market is a very emotional place, where a new price is offered to investors every day.
While many investors fall victim to the pressures of FOMO (fear of missing out) when prices rise, those who are able to recognize when a penny stock is overvalued and avoid them, are likely to increase their fortune because they lose less often.
On the flip side, an investor who is aware when a penny stock is trading below its real value has the opportunity to increase their stake in a wonderful business at a discount to its actual price.
As such, the key to making money with penny stocks is knowing what a company is worth, whether the business itself is strengthening or weakening, and when to invest in or to avoid it altogether.
We will dive further into that now.
How to value a penny stock
Learning how to make money with penny stocks is a challenging feat, but often highly rewarding when an investor can do it consistently.
Since many of these businesses are young, predicting where they will be five to ten years from now can be quite difficult.
With limited financial information to help guide your valuation, investors must rely on other fundamentals of the business to know whether they will succeed or fail miserably.
However, if you are able to understand what something is worth, the probability of you selecting winning penny stocks increases drastically because you ignore the hype and focus on value-creating businesses that are satisfying real-world demands.
To value a penny stock, here are four principles you should follow whenever analyzing a business:
1. Focus on companies you easily understand
Before ever considering whether to invest your money into a penny stock, it should be clear to you what the company is seeking to accomplish and what value they bring to the world.
Not only that, but you should be able to explain the core business model in a few sentences, while also understanding how they are going to execute this strategy better than the competition.
If it is too difficult to describe these things, then that is a fantastic indication that the company is too complicated, and you should move on to the next business.
Don’t be discouraged if this happens often.
Warren Buffett is well known for having a “Too Hard” pile on his desk as a constant reminder to stay within his circle of competence.
Being able to say “no” often to investment opportunities is one of the most enviable traits inherent in the most successful investors.
2. Only buy businesses with a proven track record (financially)
While it is understood that most penny stocks will have limited financial information, it is still important to focus on those that have something to show for it.
As such, it is better to focus on businesses with stable revenue streams, growing assets, and a loyal customer base, than to buy into something that has no revenues, but is promising fortunes with no evidence to back its claims.
That being said, the best businesses to invest in are those that are both profitable and produce cash flows because they are able to naturally grow without additional investments or financing; plus they are more likely to survive during poor economic conditions.
When you find penny stocks with these characteristics, it is a excellent sign that the business is healthy and that its customers value the products and services they offer.
All-in-all, the longer the track record, and the more financial information available, the better idea an investor has about how the business will perform.
For five stocks with proven track records, check out our article on, “The Best Small-Cap A.I. Stocks in 2022.”
3. Bet on managers who are honest, accountable, and highly motivated
Knowing the true intentions of an individual is difficult but not impossible.
While most of us will never have an opportunity to speak with an organization’s leaders, there are ways to determine whether a CEO and the management team are in it for the money or the shareholders.
Look into a penny stock’s share structure and funding rounds to see if the management’s compensation is aligned with the other owners of the business.
For example, if they were offered stock at a significantly lower price through initial funding or stock options, and they are selling immediately after their IPO, this is a major red flag and something to be wary of.
Another thing to consider is whether the management is being true to their word and if they are following through with their actions.
You can compare a company’s annual shareholder letters to its financial statements to see if they are achieving the goals or forecasts that they were promising.
Be vigilant with management teams who are overly optimistic or fail to acknowledge negative news and underperformance within the business.
4. Add a margin of safety to your penny stock valuation.
Last but not least, buying a penny stock when it is trading below its real value is the most important principle when looking to create generational wealth.
The best way to approach this is by coming up with a price that you believe the company is worth and only buying the penny stock when it is trading at a price far below this valuation.
Giving yourself a margin of safety provides excellent protection against any mistakes you may make in your valuation or risks you fail to account for.
As there is little financial info to base your valuation on, the best way to see whether a company is undervalued or not is to compare it with similar businesses in the industry.
If your penny stock’s market cap is well below that of a similar company, it may be an indication that the stock is trading at a discount.
Of course, the more information you can acquire, the better idea you will have about what something is worth.
How much should you invest in penny stocks?
The general rule of thumb for knowing how much to invest in penny stocks, or any investment for that matter, is to invest as much as you are comfortable with losing.
Since penny stock investing is considered riskier than other investment strategies, it is recommended that an investor limits their exposure to something like 10% of their overall portfolio, so that they don’t over stress about the volatility in this market.
Alternatively, investors may use a dollar-cost averaging strategy for all of their investments, meaning that they put the same amount of money into their penny stocks every month regardless of the price.
This eliminates the need to value a company, and instead, you are simply increasing your stake over time.
While both of these are sound strategies, the most effective way to capitalize on your penny stock investments is by allocating the largest portion of your money into your highest conviction bets.
If we use the 10% portfolio limit for penny stocks mentioned above, this would mean that your best penny stock could make up 7%, while your other penny stock bets make up the remaining 3%.
For example, if you were comparing two penny stocks to invest in, and one of them checks off all four principles listed earlier, while the other penny stock only checks three of them, you should invest more of your capital into the penny stock that is most likely to succeed.
Therefore, regardless of whether the stock rises 20% or falls 50%, it is easier to handle these short-term fluctuations in the stock price because you have a higher degree of confidence that this investment will perform well in the long run regardless of what chaos is happening at this moment.
All-in-all, an investor should never invest all of their money into penny stocks, but if you want to invest in this market because of the staggering profit potential, buy businesses that are positioned to last well into the future.
By doing so you will lose less often and earn more when you find wonderful opportunities.
If you are not convinced, heed this advice from legendary investor George Soros as it will serve you well during your investment journey:
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”