In for a penny, in for a pound? Penny stocks can seem appealing. The idea that an investment that costs a matter of pence could generate pounds of rewards can be beguiling.
But there are a lot of simple mistakes investors make choosing penny stocks. Here are three I’ve observed.
Focus on price not value
Here’s a thought experiment. Let’s say my children could travel to school in the cheapest bus the school can buy — or the most expensive. Which would I prefer?
The answer seems obvious. For most people, quality is worth paying for. Yet penny stocks can focus our attention on price not value.
The legendary investor Warren Buffett said that “price is what you pay, value is what you get”. A penny stock could indeed turn out to be good value. But to assess what the underlying value is, I’d look not just at the price. I’dd also consider the company’s future ability to generate profits and create shareholder value.
Penny stocks and balance sheets
One common mistake investors make is buying on share price alone without looking at the company’s balance sheet.
Imagine buying a second hand car for £100. That might sound like a bargain. But if it needs to have an MOT the following week that identifies £3,000 of necessary repairs, even the £100 price tag could seem like a bad bargain in retrospect.
It’s the same when a company has a lot of debt or other future financial obligations that dwarf its financial resources. How will it pay them? Will it have a rights issue and dilute shareholders as a penny stock like Hammerson did last year?
Balance sheets scare many people. But they aren’t as technical as they may sound. Before investing in any penny stocks I’d always spend at least a few minutes looking at a company’s recent balance sheets. Seeing what a company’s debt profile looks like is a crucial indicator of its financial health, in my view.
Single-asset focus
A lot of penny stocks are exclusively or mainly focused on a single asset. I find that’s particularly true with early-stage resource stocks. For example, Bacanora Lithium is pinning a lot of hope on one project in Mexico.
Sometimes, such a focus is positive and a lack of diversification can amplify rewards. If a company owns one mining licence and literally strikes gold, its return on capital could be huge.
But the reverse is true as well – if a company is over-concentrated in one asset, the lack of diversification can disproportionately damage it. Single-asset focus improves potential reward only by increasing potential risk, in many cases.
That matters because, as Warren Buffett reminds us: “Rule number one: never lose money. Rule number two: never forget rule number one”. That can be hard to do. But by learning from common mistakes other investors make, I hope I can improve my likely returns when identifying penny stocks to consider for my portfolio.