If you are looking to invest in the best Canadian penny stocks, focus on stock quality—and make sure it has experienced management, as well as these 6 other elements

Penny stocks are often unproven companies, which makes them highly speculative in nature. Stock prices of penny stocks do reflect that risk, but the low prices can prove irresistible to investors looking for the next “big thing”. That’s especially so if they’re already interested in finding future top performers while they’re still at or near the penny stock range—before a broad mass of investors takes notice, and the stock price begins to climb.

For those who can accept the risk, the best Canadian penny stocks can pay off. Even so, they should always make up a limited portion of your portfolio.

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7 main factors we look at when picking the best Canadian penny stocks

Often, using the terms “investment quality” and “best Canadian penny stocks” in the same sentence is contradictory. There are, however, ways to distinguish those few better-quality stocks when looking to invest in this high-risk area. Here are seven ways you can cut your risk: 

• Avoid the over-the-counter market where regulatory reporting is lax and the market for buying and selling is usually thin. Legitimate companies worth your investment are seeking to leave the over-the-counter market as soon as possible.
• Avoid stocks trading as unsustainably high levels as a result of investor mania or broker hype. Penny stocks are susceptible to extreme highs and lows that can be influenced by such things as a major investor selling their stock (which could easily destabilize the financing of the company) or a positive news report (which, in the case of penny stocks, could send the price soaring, but for all the wrong reasons).
• Compare the market cap of the stock with the estimated future value of their assets or earning stream. Sometimes, companies need to find the money in order to quickly find a mine or launch a project to justify their current share price.
• Find companies with experienced management teams that have the proven ability to develop the mine, product or service.
• Look for well-financed companies with no immediate need to sell shares at low prices because selling would dilute existing investors’ interests.
• Rule out investing in companies that are highly aggressive or misleading when promoting themselves. Instead, focus on companies that are developing a mine or launching their saleable product or service instead of simply selling stock or telling their story. These companies are more likely to be successful.
• Seek companies with a sound balance sheet and low debt. It’s even better if there is a major partner who is financing the mine, product, software and so on through to commercialization.

What you need to know about low-quality Canadian penny stocks  

Keep in mind that investing is different from many other pursuits in one crucial way: doing the wrong thing as an investor can actually make money for you, but only temporarily.

Buying low-quality Canadian penny stocks is one of those things that can appear to be successful before it goes badly wrong. Some get hooked on it, since low-quality stocks can be highly profitable over short periods. That’s because they are generally more volatile than high-quality stocks.

Here are 2 of the biggest risks you face when you invest in lower-quality Canadian penny stocks:

1. Low-quality Canadian penny stocks are quick to fall when a bubble bursts: When a penny stock bubble bursts, prices of low-quality stocks inevitably come crashing down. After all, it’s much easier to launch a stock promotion than it is to create a successful, lasting business. Penny stocks tend to be more speculative, and are engaged in such things as finding mineral deposits that can be mined at a profit, commercializing an unproven technology or launching new software.
2. 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. 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. 

Go beyond the best Canadian penny stocks to discover three keys for long-term investment success 

You can put the odds in your favour by following two simple rules: Invest mainly in well-established companies; and spread your money across most if not all of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance, and Utilities); and avoid stocks in the broker/media limelight.

This puts time in your favour. The longer you stay invested in top-quality stocks, the more likely you are to come out ahead.

Do you find more value in the best Canadian penny stocks than in penny stocks from other countries?

Do you think some penny stocks are worth the risk, or do you avoid them altogether?