Looking for profitable penny stocks makes sense only for investors who can handle substantial risk. But for those willing to gamble, here are some key tips

Many investors are attracted to penny stocks because they appear cheap. It doesn’t take a large investment to buy a significant number of shares—for example, $1,000 can buy 10,000 shares of a stock that’s trading at $0.10. If you have a large position in a $0.10 stock, a share price rise of only $0.05 can make for a substantial 50% gain.

However, there’s a good chance the stock will decline. Being speculative ventures, the vast majority of penny stocks fail, putting your entire investment at risk if you hang onto them too long.

Looking for these main factors when searching for profitable penny stocks:

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

• We insist on political stability. For example, mineral exploration is risky enough without the threat of expropriation or onerous taxes.
• We look for well-financed penny stocks with no immediate need to sell shares at low prices, since that would dilute the interests of existing investors.
• We like to see a strong balance sheet with manageable debt. Even better, we like to see a major partner who can finance the mine, software and so on to production.
• We want to see experienced management with proven ability to develop and finance a new business.
• We avoid stocks trading over-the-counter where regulatory reporting and so on is lax.
• We avoid stocks trading at unsustainably high prices due to broker hype or investor mania.
• We compare the market cap of the stock with the estimated value of its mineral reserves, future product sales and so on. Some pennies need to find a mine, or successfully market a lot of their software, or other products, to justify the current share price and avoid collapse.

Use our “sell-half” rule with profitable penny stocks to lock in your gains

Knowing when to sell a stock is one of the most important factors in successful investing—it’s almost as important as knowing when not to sell. That’s why we advise investors to follow a key rule when it comes to rising stocks.

Selling half of your profitable penny stocks that surge helps you guard your profits. But apply this rule to more aggressive or speculative stocks, and not to the well-established stocks that may surprise you by going a lot higher in the long run.

All in all, whether your approach to investing is conservative or aggressive, the quality of your investments matter much more than your skill at selling.

However, you should be quicker to sell aggressive stocks than conservative ones. With stocks we rate as “Speculative” or “Start-up,” it pays to apply the sell-half rule.

Be especially careful with penny mining stocks

It is sometimes said that a single drill hole has a 1-in-1,000 chance of turning up an “anomaly,” or a drill result that could be a marker for a mineral deposit. However, the odds against building a mine on any one anomaly are also about 1,000 to 1. So, the odds that a particular drill hole will lead to the discovery of a valuable mineral deposit are about a million to 1.

That’s why we never recommend TSX penny mining stocks that have much or all of their value riding on a single drill hole. Instead, we want to see a series of promising drilling results, along with other encouraging development work.

Limit penny stocks to a small portion of your portfolio, if at all

When you buy penny stocks you could have a big payday if you make the right choice. But the odds against success are high. Penny stocks are almost always involved in riskier ventures, such as finding mineral deposits that can be mined at a profit, commercializing unproven technologies or launching new software.

In general, penny stocks have lower trading volumes or liquidity, and this lack of liquidity means it may be more difficult to sell a stock when you want to. They also suffer from large price fluctuations, so any bit of news will cause a penny stock’s price to rise or fall.

Ultimately, penny stocks should be limited to a small part of any diversified portfolio. And you should only buy the most speculative of them with money you can afford to lose.

Use our three-part Successful Investor approach to find the best stocks for your portfolio

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Have you ever had profitable penny stocks in your portfolio?

What is your opinion on penny stocks? Do they have a place in a successful investment portfolio or do you avoid them entirely?