Strong management and a strong balance sheet are two qualities we look for in the top Canadian penny stocks. Do you know what the other 5 are?

When you consider top Canadian penny stocks, you could have a big payday if you make the right choice. But the odds against success are high.

Penny stocks can be riskier than other investments and early success can (paradoxically) actually lead to a big loss. So keep in mind that no matter how appealing they look, you should limit penny stocks to a very modest part of your portfolio—if at all.

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The 7 qualities top Canadian penny stocks need in order to be good investments

Using the terms “investment quality” and “Canadian penny stocks” in the same sentence may seem contradictory. There are, however, ways to distinguish those few stocks that are of better quality when seeking to invest in this high-risk area. Here are seven general ways you can cut your risk with the top Canadian penny stocks:

1. Look for well-financed companies with no immediate need to sell shares at a low price because selling would dilute existing investors’ interests.
2. Find companies led by experienced management teams with the proven ability to develop a start-up mineral property, product or service.
3. Seek companies with a strong balance sheet and low debt. It’s even better if there is a major partner who is financing the mine, product or service to commercialization.
4. Compare the market cap of the stock with the estimated future value of its assets or cash/flow earnings stream. Sometimes, companies need to find the money to quickly begin building a mine or launch a project, so they’ll need to justify their current share price.
5. Avoid over-the-counter markets where regulatory reporting is lax and the market for buying and selling is thin. Legitimate companies worth your investment are seeking to leave the over-the-counter market as soon as possible.
6. Avoid stocks trading at unsustainably high levels as a result of investor mania or broker hype. Penny stocks are susceptible to extreme highs and lows that can be influenced by such things as major investors selling their stock (which could easily destabilize the financing of the company) or a positive news report (which, in the case of penny stocks, could send the price soaring, but for all the wrong reasons).
7. Rule out investing in companies that are highly aggressive or misleading with promotions. Instead, focus on companies that are developing a mine or launching their saleable product or service instead of selling stock or telling their story. They are more likely to be successful.

Bonus: Two things Successful Investors avoid with penny stocks

1. Low-quality Canadian penny stocks are quick to fall when a bubble bursts: In the 1990s, buyers of Internet start-ups made far more profit for a while than investors who stuck with well-established companies. The same thing happened when many investors bought low-quality resource stocks in 2007 and 2008, and it has happened in the past in other penny stock bubbles. When the bubble bursts, however, prices of low-quality stocks inevitably come crashing down. After all, it’s much easier to launch a stock promotion than it is to create a successful, lasting business. Penny stocks tend to be more speculative, and are engaged in such things as finding elusive mineral deposits that can be mined at a profit, commercializing an unproven technology or launching new software.
2. The longer you play, the likelier you are to lose: If you lose money in speculative or other 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. 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.

All in all, stick to our three-part Successful Investor philosophy for the bulk of your portfolio:

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; Consumer; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

The third element in the strategy outlined above is crucial in avoiding penny stock scams. Penny stock promoters focus on companies that aren’t likely to go anywhere, and merely have an indirect connection with some industry trend or development that is getting a lot of media attention. It takes a lot more than that to create a profitable business or investment. But if you let the media hoopla taint your investment decisions, you increase your risk of blundering into a promotional stock scam.

Do you think the potential for a big payday is worth the risk of penny stock investments? Why?