Energy penny stocks may seem like an intriguing early-stage investment, but the problems with these stocks are numerous, including the potential for environmentally, politically, or financially unstable situations. There are better energy stocks, with more proven prospects, for you to buy.

Penny stocks can be more easily manipulated than most stocks that trade on stock exchanges because of their generally low trading levels and resulting price volatility.

Combine this with a lack of regulatory oversight on some junior stock exchanges, and the fact that these companies are easy to launch, and you can appreciate why investment frauds are more common with energy penny stocks.

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Energy penny stocks are often involved in risky endeavours

A penny stock in general trades for under, say, five dollars a share, and as the name implies, sometimes for pennies. Most of the time they’re young firms, or start-ups in speculative markets like very early-stage oil and gas exploration, mining or technology.

Buying Canadian penny stocks can lead to a big payday when you make the right choice. But the odds against success are high. Penny stocks are almost always involved in riskier ventures, such as striking oil and gas, finding mineral deposits that can be mined at a profit, commercializing unproven technologies or launching new software.

What’s more, it’s hard for any new company to grow into a profitable business, and it’s even harder in pioneering fields. But it’s relatively easy to launch a stock promotion that purports to have answers to social problems or ways to profit from emerging technologies.

Other potential problems of energy penny stocks

• Bad penny stocks require the most intensive marketing and promotion
• Major company involvement is frequently exaggerated with hot penny stocks
• Penny stocks can be riskier than other investments

We don’t recommend investing much—if anything—in energy penny stocks

If you lose money in speculative or other low-quality stocks (or ETFs that invest in low-quality stocks), you may think your main mistake was bad timing. That’s a misconception. You can get lucky in penny stocks, just as in lotteries. But if you play long enough, the “house odds” eventually triumph over any run of luck. In penny stocks or games of chance, the odds are against you. The longer or more often you play, the likelier you are to lose.

Only a minority of penny stocks ever go on to significant success. And while some hot penny stocks can be a worthwhile addition to the aggressive portion of a diversified portfolio, you should in general only buy them with money you’re willing to lose.

Learn how to invest in low-risk energy stocks instead of focusing on energy penny stocks

Rather than penny stocks, look for energy company stocks that are well-financed companies with no immediate need to sell shares at low prices. These stocks typically have strong balance sheets with low debt.

We look for an experienced management team with a proven ability to develop energy. We make sure they’re not in any insecure or politically unstable regions such as the Congo and Venezuela, or in countries with little respect for property rights and the rule of law such as Russia or Mongolia.

We avoid any energy stocks that trade “over the counter,” where such things as regulatory reporting are lax. And we don’t invest if the stock is trading at an unsustainably high price, because that is likely to be the result of broker hype or investor mania.

We also look at the market cap of energy stocks versus the estimated value of the reserves they have in the ground. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of its reserves. We like an energy stock’s market cap to be no more than half the value of those reserves. We assume that the company will be able to expand its reserves through exploration, but if the reserves are double the energy stock’s market cap, it provides a margin of safety.

Energy stocks were generally below-average performers for some time, and many investors were tempted to get out of the industry altogether. However, the energy segment can play a crucial role in your portfolio as a hedge against inflation. The low inflation rates of the past couple of decades deserve much of the blame for the poor performance of the industry. When they rebound further, energy stocks could grow significantly for years to come.

You can profit over the long term by investing in well-established and well-managed companies that are active in businesses involving highly volatile commodities such as oil and gas. You profit all the more if you buy these companies when they are cheap in relation to earnings, cash flow and assets.

What would persuade you to invest in energy penny stocks that were based in politically unstable locations, or ones that were controversial due to environmental impact?

While many energy penny stocks can lead to a loss, some will occasionally turn into promising investments. What is your experience with energy penny stocks?