The best penny stock mining companies to invest in are not overly promotional, have strong management, and are reasonably well funded

Penny mining stocks are some of the riskiest stocks Successful Investors—or any investors for that matter—can buy. These companies typically aim to find mineral deposits with mine-making potential—but such finds are exceedingly rare. Because of this, it’s even more important to try to maximize investment quality in penny mines.

If you do invest in penny stock mining companies, first scrutinize them carefully. Here are some tips on how to do that:

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Many investors overvalue the penny stock mining companies they look at

Make a wrong move, and investing in penny mines can cost you a big part, if not all, of your investment.

In the 18th century, pioneer economist Adam Smith (author of The Wealth of Nations) wrote that the public tends to overvalue what he called “speculative ventures.” The world has changed a lot since then, but his warning still applies—especially when it comes to penny mining stocks. These are low-priced stocks (often traded in pennies, but perhaps as high as $5 a share) that often have a mineral property that they hope will hold a substantial mineral deposit that can in turn be transformed it into a profit-making mine.

As mentioned, the investing public as a rule tends to overvalue penny mines. Investors pay too much attention to the vast profits that may come with success, and too little to the obstacles that stand in its way. The vast majority of penny mines fail to achieve their goal.

Major company involvement can be exaggerated by penny stock mining companies

Penny stock promoters love to make deals—however minor or indirect—with major, household-name companies. They’re sure the public is far more likely to buy penny stocks that have agreements with large well-established clients. For example, a mining penny-stock may promote that Newmont Mining, BHP Billiton or another major mining company has decided to finance exploration of their mining claims.

However, 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.

Above all, remember that big companies have far more bargaining power than individual investors.

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 (or in the case of other penny stocks, new technology or pioneering programs), 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 investment of $5 million—if this means it will get a chance to develop the one rare project that is ultimately worth an investment of, say, $500 million. If it waits until the property, technology or program has proven itself, development rights will be far more costly. So it gets in early by investing what are just token amounts of money for a major firm.

That’s why big-company involvement by itself is never a good reason to buy shares of penny stock mining companies.

Look for these key characteristics before you invest in penny stock mining companies

In general we avoid penny stocks that promote themselves too aggressively (or do so misleadingly). Here are eight more things we look for when we analyze penny mining stocks for Stock Pickers Digest, our newsletter for aggressive investing. 

• 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.
• We want to see experienced management with a proven ability to develop and finance a mine.
• When investing in penny mining stocks, look at environmental constraints in places where junior miners are exploring for minerals. In Europe and certain parts of the U.S., junior miners need a particularly rich find to justify the costs of overcoming environmentalists’ objections.
• Ideally we want to see positive cash flow, preferably even when commodity prices are low.
• We prefer, if possible, to see mining companies that have cash flow from an existing mine that is sufficient to cover, or at least contribute to, the cost of developing a second mine.
• We avoid mining stocks that trade at unsustainably high prices because of broker hype or investor mania.
• We think you should avoid stocks that trade over the counter, where such things as regulatory reporting can be lax.
• We also like to see a reasonably sound balance sheet in 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.

Bonus tip: Follow our three-part Successful Investor strategy for the bulk of your portfolio—and keep penny stocks to a very small part

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Environmental restraints often hinder mining exploration. Do you avoid miners operating in certain locations or under certain governments due to possible liabilities?

Even with the risk, a penny stock mine can produce a profit. What similar traits have you found in these successful mines?