Watch out for penny stock companies that spend more on promoting their shares than developing their business

Penny stocks do sometimes pay off, but there are many pitfalls to avoid. You should be aware that many penny stocks are little more than very well executed marketing campaigns. Those penny stock companies will do anything in their power to get their penny stock noticed. These extensive marketing campaigns include emails, TV interviews, podcasts, newsletters and other paid sponsorships.

There are also some so-called news sites that will sell sponsorships to penny stock promoters. These are great opportunities for penny stock companies and promoters—but bad for investors looking for an unbiased opinion on a stock.

What penny stock investing scams look like:

Penny stocks can be more easily manipulated than most stocks that trade on 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 penny stocks.

Penny stock promoters sometimes aim to make companies appear bigger than they are

Penny stock promoters love to make deals (however tenuous or indirect) with major, household name companies. The link with a major gives them instant credibility, especially with investors who are willing to buy penny stocks.

When penny stock promoters get a deal with a major, they go to great lengths to make it seem bigger than it is.

In fact, when a penny stock shoots up on the news of big-company involvement, and the mineral property/unproven technology/revolutionary software is still in the early stages of development, it’s often a good time to sell.

What penny stock companies don’t want you to know: The longer you play, the likelier you are to lose

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.

Sometimes you might get lucky for a short time—for example, in the early 2000s, buyers of Internet start-ups made far more profit than investors who stuck with well-established companies.

In penny stocks or games of chance, the odds are against you. So, time works against you. The longer or more often you play, the likelier you are to lose.

That’s also why we think you should apply our sell-half rule.

Selling half your holdings after you double your earnings is a good strategy for any high-risk investment, but especially so for penny stocks.

Six ways to profit from penny stocks

In general we avoid penny stock companies that promote too aggressively, or do so misleadingly.

Here are six more things we look for when we analyze penny stocks:

• Only buy penny stocks with money you can afford to lose. Ultimately, Canadian penny stocks should always be a small part of any diversified portfolio.
• Spread your penny stocks out across different market segments. When making a list of penny stocks, we recommend investing in a range of markets. This includes software, biotech, technology, mineral exploration and so on.
• Look out for acquisitions. Acquisitions can bring “time-bomb” risk. Companies sometimes grow quickly by buying other companies. But it may also be the case that those selling the companies may simply want to bail out of a losing situation.
• Focus on up-and-coming technologies. To do this, you need to know how technology is changing. For instance, the immense popularity of wireless devices, like the iPhone and tablet computers, stepped up demand for faster, more reliable wireless networks.
• Buy multi-product companies. Technological advances come in spurts, and they leapfrog each other. Focus on tech penny stocks that have some existing or soon-to-be-released products, and avoid one-hit wonders.
• Avoid Canadian penny mining stocks that trade at unsustainably high prices. Instead, we focus on reasonably priced Canadian penny mining stocks with favourable geology.

It’s essential to avoid letting an investment opinion turn into a fixed idea about the future value of an investment. Instead, keep an open mind. Nobody can consistently predict what stocks will do. You should always look on your opinions as tentative and subject to continual review, in light of any new information that comes along.

Have you ever had a negative experience with penny stock companies? Please share your story with us in the comments.