Penny stocks 101 for new investors considering investing in penny stocks

Creating a list of penny stocks is easy, but generating a list of penny stocks with an above-average chance of success is much more difficult.

Penny stocks tend to be 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, but while you’re creating a list of penny stocks that appear to be suitable investments, keep these penny stocks 101 tips in mind.

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Penny stocks 101: the worst penny stocks require the most intensive marketing and promotion

Penny stocks do sometimes pay off, but there are many pitfalls to avoid. You should be aware that many penny stocks are little more than very well executed marketing campaigns. Penny stock promoters will do anything in their power to get their penny stock noticed. These extensive marketing campaigns include emails, TV interviews, podcasts, newsletters and paid sponsorships.

There are also some so-called news sites that will sell sponsorships to penny stock promoters. These are great opportunities for penny stock promoters but bad for investors looking for an unbiased opinion on a stock.

Penny stock promoters love to make deals—however minor or indirect—with major, well-known firms. These deals are aimed at gaining the trust of investors. For example, a penny stock may issue a press release about how Sony, Apple or some other household-name multinational has agreed to sign them up as a “channel partner” to potentially co-market a computer program or electronic gadget. The penny stock hopes that the link with a major brand will give them instant credibility, even if it far from guarantees any sales or profits.

Not all penny stocks and their promoters are out to cheat investors. But it’s important to approach any penny stock with a healthy dose of skepticism.

Penny stocks 101: Main factors we look at when picking penny stocks

• 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 low 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.

Penny stocks 101: The longer you play, the likelier you are to lose

If you lose money in speculative or other low-quality stocks (or ETFs that invest in low-quality stocks), you may think your main mistake was bad timing. That’s a misconception. You can get lucky in penny stocks, just as in lotteries. But if you play long enough, the “house odds” eventually triumph over any run of luck.

Sometimes you might get lucky for a short time—for example, in the early 2000s, buyers of Internet start-ups made far more profit than investors who stuck with well-established companies.

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 also why we think you should apply our sell-half rule.

Selling half your holdings after you double your earnings is a good strategy for any high-risk investment, but especially so for penny stocks.

Did our penny stocks 101 post teach you more about investing in penny stocks? Do you currently hold penny stocks in your portfolio? How have they performed? Share your experience with us in the comments.