Value in Penny Stocks

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“Value and penny stocks?” you’re asking yourself. You scoff. These companies rarely have a clean balance sheet, many don’t show any profits, and some don’t even have a product! How do you find value?

As my mother said, value is in the eyes of the beholder.

Okay, maybe my mom said “beauty” is in the eyes of the beholder, but don’t you think that value is a beautiful thing? Finding a value stock hidden among the penny stocks is like finding a four leaf clover. At first you can’t believe your luck. Then you don’t trust yourself and search the internet to understand why nobody else found it. Then you invest. In many cases, it’s only a matter of time before the world discovers the stock and you’re off to the bank with a large, large deposit.

Much as with larger stocks, penny stock valuation is part science and part art. Some stocks appear to be a value play on the surface, but they’re just bad stocks. They have too much debt, executives that are too highly paid, a product mix that’s competing with the big boy companies, or an ineffective marketing strategy. Using a few simple techniques, you’ll be able to search penny stocks looking for discounts like you would at the neighborhood garage sale.

The definition of valuation is different to a penny stock trader than to a large company investor. In the penny stock market you need to look at the company through the eyes of someone who would buy the entire company, rather than as an investor hoping to earn a few nickels on an increasing share price. Searching for the appropriate price for most penny stocks is nearly impossible, partly because of the speculation in these markets but also because of the lack of earnings and diversified products for most of these companies. Your goal when looking for a “deal” is to find, before larger investors, companies that are good targets to be swallowed. Even if they don’t end up being purchased, the chance that they might be “in play” will increase speculation, which in turn increases volatility. Volatility to a penny stock investor means good potential for profits.

Here are some penny stock value measures:

1) Look for improving earnings and a flat stock. Companies showing improving earnings year over year while the stock remains the same price are bound to take off—assuming other fundamentals aren’t killing the stock, such as too much debt or a high cost of revenue. Improving earnings creates value because sustainable sales are used to improve the selling price of the company to potential buyers.
2) Find low debt levels. It’s difficult for large company management to justify to shareholders why they bought a company with mountains of debt and little revenue. In some cases a large company will buy a debt-ladened penny stock, but if you’re the CEO of a Fortune 500 company wouldn’t it be easier to explain a company with a great product and not much debt? You might even pay more for this type of investment. Value!
3) Explore companies that have buy-back plans. The number of shares on the market is called the “float.” As an investor in a penny stock, you’d rather own as many shares as possible, wouldn’t you? Every time a company takes shares off the market the value of your shares increases. Companies which consistently buy back shares are using this as a global corporate strategy and will probably continue buy-backs in the future. On the flip side, avoid companies constantly diluting your shares by selling new ones. This decreases your value in the company and could signal cash flow difficulties ahead.
4) Mutual fund and pension fund ownership positions. These large, influential investors often are able to throw around their weight with management to protect their investment. To ensure they get results from their penny stock, they’ll help create alliances, recommend top notch advisors and executives. Although rare, mutual fund or pension fund involvement in a penny stock is very, very good for valuation.

Sometimes all of your fundamental analysis points to a good stock, but you are afraid to purchase the position because everyone else decided to purchase the day before you did, creating a nice, big spike in the price. You certainly don’t want to overpay for an issue, so you’ll need to follow a few techniques to improve your odds of purchasing a stock “on sale.”

1) Watch your favorite stock’s volatility. Is there a rhythm you can follow? If the stock spiked because of a press release or investor hype, there’s a fair chance you might get another opportunity to buy. Place a limit order to purchase the issue near the bottom end of the stock’s usual swing.
2) Always use limit orders. Penny stocks can move in a hurry and in more than one case I would have purchased a stock for far more than I wanted to pay if I’d just issued a simple market order. Limit orders allow you to set a price you don’t want to purchase above. If the stock is trading at $.62, I may place a limit at $.65 or $.66.
3) Follow short interest. Shorts will sell after they feel like they’ve flushed every profit nickel out of the issue. At the end of a short-rally the stock will fall quickly. Although you have to ask yourself why you’d get involved with a stock that is a short favorite, if you feel strongly, wait for the rush to end and you’ll be able to purchase when it falls back to its normal trading range.

Penny stocks may be considered value plays if you redefine your concept of what constitutes a bargain. In the penny stock world, searching for value is just another way of saying you’re looking for big profits that haven’t yet been discovered by the masses. Happy hunting.

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