Want to invest in the top penny stocks but aren’t sure what to look for? Here are some key tips for maximizing your gains

Even though the top penny stocks are appealing to some aggressive investors, they tend to be considerably 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.

Not all penny stocks will go bust, and sometimes penny stocks do pay off. And when you see a list of top penny stock picks online or elsewhere, you may be inclined to invest in at least some of them. But there are many pitfalls to avoid. And while some penny stocks do take off, you should be aware that many penny stocks are little more than very well executed marketing campaigns.

Five ways to profit from top penny stocks

In general we avoid penny stocks that promote themselves too aggressively (or do so misleadingly). Here are five 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 new company.
2. We look at environmental constraints in places where junior mines are exploring for minerals. In Europe and certain parts of the U.S. a company needs a particularly rich find to justify the costs of overcoming environmentalists’ objections.
3. When we recommend junior stocks exploring 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.
5. We also like to see a sound balance sheet in all the penny stocks we recommend. We like to see enough cash to keep operations going without the need for dilutive share issues at low prices.

The best of the top penny stocks are not marketing promotions in disguise

Beware of companies that are more interested in boosting their stock than in building their business.

Penny stock promoters love to make deals—however indirect—with major, household-name companies. That’s because they think the public is far more likely to buy penny stocks that have agreements with Teck Resources, BHP Billiton or some other major mining company to finance exploration of their mining claims. Or if Sony, Apple or some other household-name multinational has agreed to evaluate their computer program or electronic gadget. The link with a major aims to give them instant credibility, especially with investors who buy penny stocks.

However, 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.

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.

That’s why big-company involvement by itself isn’t a good indicator of a penny stock to buy—in fact, it can be an reason to sell penny stocks.

Two keys to long-term success with top penny stocks

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). You can do so directly, by selecting stocks from our recommendations in The Successful Investor, or by investing in ETFs that hold these types of stocks.

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

Apply our sell-half rule when investing in the top penny stocks

Selling half your holdings after you double your earnings is a good strategy for any high-risk investment, but especially so for penny stocks. This can give you a clearer perspective on what to do with the other half of your investment. After all, if you are too slow to sell speculative stuff, your profits and even your principal can evaporate all too quickly.

If you lose money in penny stocks, you may think your main mistake was bad timing. That’s a misconception. You can get lucky in making a list of 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.

Have you succeeded in finding a top penny stock that has performed exceptionally well while not leading to a big loss?

If you’ve invested in penny stocks, chances are good that you’ve lost money, but have you ever made money with them?