Learning which penny stocks to invest in should lead you to pennies with strong management focused on developing a saleable product or service, rather than hyping their story

Top-quality stocks tend to lose less of their value in the kind of severe market setback we’re experiencing today. They also tend to bounce back nicely when conditions improve. These are the kinds of stocks we continue to recommend in our newsletters and other services.

To build a portfolio of those stocks—and to show the best long-term results, Pat McKeough still thinks you should stick with his three-part program:

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.

Meantime, some investors look to penny stocks as a quick way to boost their investment gains. While buying penny stocks can lead to a big payday, even when you make the right choice, the odds against your success are high. Penny stocks are almost always involved in riskier ventures. Even if you want to take on that risk, you need to be extra careful about the penny stocks you buy. Here’s what to look for:

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Look for the following when analyzing penny stocks

• Strong management: Look for an experienced management team with a proven ability to develop and finance a mine, product or service.
• A strong balance sheet: High-quality penny stocks should have balance sheets with manageable debt. It’s even better if they have a major financing partner.
• Well-financed companies: To profit in penny stocks, you should look for well-financed companies with no immediate need to sell shares at low prices, since that would dilute existing investors’ interests.
• Stocks trading on a well-regulated exchange: We think you should avoid stocks trading “over-the-counter,” where such things as regulatory reporting are lax. Stick to penny stocks trading on regulated exchanges like the Toronto and New York stock exchanges.
• A results-focused company: Automatically rule out investing in companies that promote themselves too aggressively or do so misleadingly. Success is more likely if the managers focus on developing a saleable product or service, rather than hyping their story.
• Reasonable share prices: Compare a stock’s market cap (the total dollar value of all of a company’s outstanding shares) with the estimated value of its assets or future earnings stream. Most penny stocks won’t be able to successfully launch a product with enough success to justify its current share price and avoid collapse.
• Look past the hype: Avoid stocks that are trading at unsustainably high prices as a result of broker hype or investor mania.

Use caution when considering which penny stocks to invest in because the longer you play, the likelier you are to lose

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 why if you do invest in a penny stock that rises, we think you should apply our sell-half rule.

This rule says that if you own a stock and you have doubled your money in it, you should sell half—so you get back your initial stake. By recovering your initial stake, you’ll be able to think more clearly about the stock.

However, note that overall, the sell-half rule applies mainly to stocks we rate as Start-up or Speculative.

Every case is different, but generally you should hold on to high-quality stocks even if they have doubled in price. One exception would be if a conservative stock rises such that it makes up too high a percentage of your portfolio after doubling, say, 10%. Then you should at least consider taking some profits.

Sometimes, well-established stocks get so high priced that we advise selling simply because they have gone too high in relation to their prospects. But as a general rule, it pays to be slow to sell your conservative winners, and quick to sell aggressive or speculative winners—including penny stocks.

At the same time, though, 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 charts to climb and dive precipitously.

Bonus tip: Make high-quality blue chip stocks the cornerstone of your portfolio

Blue chip companies can give investors an additional measure of safety in volatile markets. And the best ones offer an attractive combination of a moderate p/e (the ratio of a stock’s price per share to its per-share earnings), a steady or rising dividend yield (annual dividend divided by the share price), and promising growth prospects.

Most successful blue-chip stocks have these qualities in common:

• The most successful stocks come from successful companies.
• The most successful stocks maintain or increase their dividends.
• The most successful stocks have strong balance sheets, hidden assets, and experienced management teams.

What would entice you to invest in a penny stock? Would it need to be a particular product or would your decision be based entirely on numbers?