Some investors think the best way to profit in stocks is to buy them when they are just barely starting out on a growth phase they hope will last for years if not decades. Ideally, they want to buy the future top performers when they are still near or close to the penny stock range and have yet to be discovered by the broad mass of investors.

And it’s true that 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.

What’s more, it’s much easier to launch and promote a stock than it is to start a successful business. So penny stocks attract more than their share of unscrupulous operators and stock promoters.

Look out for over-publicized deals

Penny stock promoters love to make deals with major, household-name companies. They’re sure the public is far more likely to buy penny stocks that have agreements with Teck Resources, BHP Billiton or another major mining company to finance exploration of their mining claims.

1. Major company involvement is frequently exaggerated: When promoters manage to make a deal with a major firm, they often go to great lengths to make it seem bigger than it is. Instead of announcing that the big company has invested, say, $50,000, a stock promoter may issue a press release saying the two companies have entered into a “multi-stage development plan.” The release may say the major company has agreed to spend “up to $10 million” or some other exalted figure. It will usually provide a toll-free number or web address for investors to order or download the glossy brochures.

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1. Big companies have far more bargaining power than individual investors: It pays to remember that a big company doesn’t go into a situation like this the same way you do. If the big company agrees to spend $50,000 to study the mining property, new technology or pioneering program, it will also insist on a series of options that let it invest ever-larger sums on favourable terms. But the big company will always reserve the right to drop out and cut its losses. In most cases, it will exercise that right.

   A major mining company will gladly spend $50,000 one hundred times, and lose every penny of it—a total outlay of $5 million—if this means it will get a chance to develop the one rare project that’s ultimately worth an investment of, say, $500 million. If it waits till the property, technology or program has proven itself, development rights will be far more costly. So it gets in early by investing what are really just token amounts of money for a major firm. That’s why big-company involvement by itself is never a good reason to buy penny stocks.

Watch for these 4 factors when choosing penny stocks

In addition to avoiding Canadian penny stocks that promote themselves too aggressively (or do so misleadingly) here are 4 more things we look for when we analyze penny stocks for Stock Pickers Digest, our newsletter for aggressive investing.

1. We want to see experienced management with a proven ability to develop and finance a mine.
2. We look at environmental constraints in places where junior mines are exploring for minerals. In Europe and certain parts of the U.S., junior mines need a particularly rich find to justify the costs of overcoming environmentalists’ objections.
3. When we recommend junior mines that only explore for minerals, we prefer those that operate in an area whose geology is similar to that of nearby producing mines.
4. We think you should avoid stocks that trade over the counter, where such things as regulatory reporting are lax.

Investors in penny stocks also face one overriding, continual risk: it’s easier to launch a promising company than to create a successful business. That’s why only a minority of junior companies ever go on to significant success.

COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members

If you invest in penny stocks, it is an occasional fling, or do you try it fairly often? What is the most important thing you feel you need to know about a penny stock before you invest? Let us know what you think.