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High-risk investments
Penny share profits
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How to make money from penny shares
Most define a penny share by its upper price limit. In the UK, some specialist brokers require a share price of less than £1.00, while others set the ceiling at £3.00.
Whichever way, penny shares are the fun side of investing but, also, unfortunately, its crooked side. Other things being equal, the younger the company in which you invest, the greater the risk.
The investment risks and the rewards are enhanced, not least because penny
shares have a thin market. A stock priced at 10p
may rise
50%
on good
news, whereas
an
old
economy blue chip stock will not. Conversely, the penny share can fall more
sharply in percentage terms than its larger cousin. Its price at any given
time may bear no relation to the stock's underlying value.
A penny stock may prove very profitable if predators are showing an interest.
The share price can soar on speculation that there may be a contested takeover
bid at a considerably higher value than the current share price.
For such reasons, you will not always buy penny shares on value grounds. You need to be ready to nip in and out of stocks, keeping a sharp eye on share price changes. In addition, you will find some penny shares in which it is worth investing for the longer term.
The choice of markets is large, making a difference to the company's profile,
its liquidity, and its expenses. A company may be quoted on the London
Stock
Exchange's main market
or on its Alternative
Investment Market. Alternatively, it may be PLUS-quoted. Stocks quoted abroad
may be simultaneously trading on the London Stock Exchange.
Penny share categories
1. Recovery stocks
Recovery stocks have seen better days but have fallen out of favour. They were once perhaps stock market darlings. They have often survived only because they restructured their business.
A favourite recovery situation is the shell company, which is a quoted company
that does not trade. A dirty shell is an ex-operating business. A clean shell
will have been formed to seek acquisitions through a reverse takeover. In practice,
a deal may not happen quickly, and it can be better to invest in a shell only
after it has announced a deal. Changes in disclosure rules
for stocks on the Alternative Investment Market have made it less risky to
invest in shells. Any shell admitted to this market
before 1 April 2005 which raised less than £3 million at admission was
required to make an acquisition or to carry out its investment strategy by
1 April 2006. Companies that failed to meet the criteria were suspended from
trading.
2. Cyclical stocks
Cyclical stocks rise and fall in value with the business cycle. For example, mining and resource companies may close their operations in the winter due to bad weather, and the share price would decline to reflect this. They would resume activity in the spring and summer, and the share price would duly rise again.
The most reliable area of cyclical investment is house-building and related activity. When the economy looks strong, invest in such companies as they will be reaping the benefits of a housing boom.
3. Technology companies
Internet companies may have few or no tangible assets. The share price may rise
or fall rapidly within weeks.
If you are thinking about investing in a technology company, check
that it has significant revenues. Look for earnings either now or in the foreseeable
future.
Also, look for a strong business model. For promising companies without earnings,
a favourite valuation method is the price/sales
ratio.
4. Biotechnology companies
Young biotechnology companies are a particularly high-risk investment. Fewer than 10% of their products reach clinical development, although the success rate improves as production leaps early hurdles.
When selecting a biotechnology company in which to invest, look for a pipeline
of at least several products, and a partnership with a major pharmaceutical
company that will provide crucial finance in the early years in return for
a stake in the profits.
Compare cash burn, which is cash spent, with cash held, and watch how close
key products are to completion. If a main product fails, the share price may
collapse. In 1996, British Biotech’s shares were 300p, but they plummeted
after the company’s cancer drug Marmistat turned out to be ineffectual.
By June 2000, the share price was as low as 19.25p.
Select your own stocks
In selecting penny shares, bear
in mind that they are not subject to the usual stock valuation rules. The level of PE ratio,
for instance, will rarely make much difference as the share price is highly susceptible to
fluctuating market perception.
A penny stock will ideally have a net asset value per share that is higher than the share
price. This will help it to survive through lean times, or worse. If a company is wound up,
the liquidator will distribute to shareholders in proportion to the company's assets.
Do not look for asset backing in a young Internet company. It will have none unless perhaps
it combines an established bricks-and-mortar business with an Internet division poised for
growth. This will arguably reduce the growth potential as well as the risk for investors.
Try to predict rather than reflect trends in your stock selection.
If, for instance, you discover that a pharmaceutical company is about to publish
the anticipated good results of drug tests, and this is not yet reflected in
the share price,
invest early. If the test results meet expectations, the share price could soar.
On the flip
side, shun shares that are blatantly over-puffed.
When you assess the company's management, look for leadership as well as any required
technological expertise. The two do not always come together. A positive change in management
may send the share price soaring.
Above all, conduct your own research on penny shares. Use what you read in the
press or tip sheets, if at all, as a starting point. The tip
sheets on penny (and other small company) stocks vary in quality. To find
out more, click
on Share tipsters exposed.
For more on penny shares, read:
How
to Win as a Stock Market Speculator by
Alexander Davidson, published by Kogan Page.
Also read Everyone's
Guide to Online Stock Market Investing by
Alexander Davidson, published by Kogan Page, 2001.
To check out a penny share, go now to our renowned Penny Share Performance Assessor.
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