Should you invest in penny shares?

Penny shares

In the late 1980s my father subscribed to a penny share newsletter delivered by post each month.

I remember vividly two of the stocks my father bought on the recommendation of the newsletter - West Midlands engineer Benjamin Priest and Dublin-based oil explorer Tuskar Resources.

The former was taken over several times, although we made hardly any money, while the latter went bust following the failure of an oil deal in Nigeria.

This type of tip sheet still exists, although these days you're more likely to subscribe online than wait in for the postman to deliver.

Continued improvements to the internet over the past 25 years have also made it much quicker and easier for investors to do their own research.

PENNY SHARES

It's part of the reason why investors love this end of the stock market. There's still a perception it is where fortunes are made. And it can be. But it is where your money can quickly vanish.

Many penny shares are often loss-making, or at least do not make very much, often consisting of little more than a hole in the ground, some untested technology, or an idea and some start-up cash.

In the FTSE Aim All-Share index there are currently 128 companies whose shares are trading at less than one penny. More than 350 stocks change hands for less than 10p, and well over 600 trade at under 100p. Even in the FTSE All-Share there are more than 50 companies whose shares trade at less than 100p.

Of course, every company has to start somewhere. GlaxoSmithKline began as a pharmacy in eighteenth-century London; Lloyds was a private banking business in Birmingham at around the same time, while BT was born a few decades later. And there are more contemporary examples of rags to riches stories.

The hugely successful high street fashion chain Next, for example, traded at around 13p in 1991, and countless big names - think Lloyds, Royal Bank of Scotland and GKN - plunged to unheard-of lows during the financial crisis: more a case of riches to rags to riches again.

However, the companies we commonly refer to as penny shares are the minnows. There will inevitably be failures - at least in terms of returns for shareholders - but what draws investors back to the casino end of the market is the prospect of picking the one that makes it: the stock that rockets 7,000 per cent in one month.

And it does happen. Wearable fitness device company Fitbug did just that, as recently as October last year. Having done almost nothing for four years, and trading at just 0.375p, the share price rocketed to 26.5p in little more than five weeks.

And in recent weeks, UK Oil & Gas, part of the consortium that struck oil near Gatwick Airport, surged more than fivefold within days, to 4.75p. There are many more examples of penny share successes in recent years - check out Crawshaw, up 2,475 per cent, Trakm8, up 980 per cent, and Safeland, up 871 per cent.

MONEY DOWN THE DRAIN?

So, there's a fortune to be made if you pick a winning horse, but the list of losers is longer. These tiny companies should come stamped with a huge health warning. Many never amount to much, while others run out of cash and disappear. Even the former stars can come a cropper.

Fitbug is currently trading at 6.7p - up 1,687 per cent from its October low - but the shares are down by three-quarters from their high. And African Minerals is a lesson to all penny share investors.

Trading below 13p in 2008, the company quickly became the largest iron ore miner in Sierra Leone, and the largest company trading on Aim - worth over 650p per share, or more than £2 billion at its peak.

Founded by controversial entrepreneur Frank Timis, it was the biggest employer in the West African country. But some colourful forecasts and a plunge in iron ore prices brought the firm to its knees. It eventually went bust in March this year.

Clearly, the downfall at African Minerals owed a lot to mismanagement, but it does raise the issue of what can go wrong even once the hard work has, seemingly, been done.

Indeed, often there is little by way of fundamentals to hold up the share price of many penny shares after a meteoric rise; it's just investor optimism. These companies cannot afford to miss forecasts.

PEAKS AND TROUGHS

Investors often end up owning penny shares longer than they perhaps intended, especially if they want to turn a profit.

True, many buy for the long term, preferring to stick them away in the hope they might one day become the next GlaxoSmithKline. That's fine, but speculators can help cause wild gyrations in share prices.

Understandably, penny share prices get over-excited on good news. New buyers chase the shares higher for a period before the inevitable sell-off begins. The rally can be over as quickly as it began, as in the case of Fitbug.

This happens for several reasons. First, some investors will have got in at much lower levels and will be willing sellers at higher prices. Market makers may also try and shake out sellers by marking the shares lower. Buyers then move in at cheaper prices. It's great two-way business for market makers.

Many penny shares - and not just mining and oil stocks - make little or no money. A contract win here, a deal done there, can therefore have a significant impact on profits.

Valuing a company's shares is difficult enough for large companies, but valuing penny shares is almost impossible - buying Fitbug at, say, 6p was a great trade when the shares hit 26.5p, but not so great for the buyer who paid 26.5p!

Penny shares are traded like any other share, and are almost always quote-driven prices - a buy and sell price given by one or more market makers (share prices for larger, more liquid companies are typically order-driven - investors' own buy and sell orders create a natural two-way quote).

For penny shares, however, this is impractical, given the liquidity issues that plague many listed smaller companies. Many are still owned by the founders who control a chunk of the shares.

Fewer shares in circulation typically means market makers will quote wide spreads, yet even small buy or sell orders can still move a share price quite sharply. It may even be impossible to deal at anything like the price being quoted by the market maker.

Take a look at Gate Ventures if you're unsure. It listed at 10p a few months ago, but the shares now trade at almost 200p. There are some other issues at Gate, but brokers tell me there's a severe lack of stock, which means the market makers will not price the shares lower.

SHOULD I BUY PENNY SHARES?

Penny shares are clearly not for widows and orphans. If you want low-risk returns and reliable income, they should be treated as off-limits.

However, for investors with an appetite for risk, small company shares should not be discounted entirely. Despite the long list of losers, enough decent companies exist on Aim to make further investigation worthwhile.

Yes, there is a shortage of publicly available research on many penny shares, but it is possible to unearth reliable information from company statements and press reports. Try the company website, too.

If you do decide to take the plunge, never invest more than you are willing to lose, and make sure high-risk assets make up only a small portion of your investment portfolio.

10 TIPS TO PROFIT FROM PENNY SHARES

Do as much research as possible

Small companies may have shorter trading histories, but track down as much information as you can, and be sure to pick through at least the most recent set of accounts.

Treat tip sheets with scepticism

Some tipsters do an honest job; others are less scrupulous and clearly attempt to ramp bad companies. They should be avoided.

Go for quality

Buy the shares of companies with a reasonable trading history, which make money and can demonstrate some level of growth. Failing that, look for potential at the very least.

Avoid emotion

Becoming emotionally attached to a stock is one of the most common reasons why investors lose money on small-cap trades. Do not be disabled by blind faith.

Stick to a stop-loss system

It's never pleasant to lose money, but if a trade is going wrong, limit the damage. However, wide spreads and extreme volatility can make it tricky to execute.

Higher volume stocks are best

Trading tiny stocks with little, if any, volume can make it more difficult to close out positions.

Don't try and buy everything

There are hundreds of penny shares, but not all will be suitable for every investor. Stick to sectors or a particular type of company that you feel most comfortable with.

Never be afraid to sell

Knowing when to sell a share, large or small, is hard. Remember, it's never wrong to take a profit. Often, penny shares are short-term trades, too.

Avoid over-exposure

Penny shares should only ever make up a small percentage of an investor's overall portfolio. Over-exposure increases risk and ties up capital.

Don't bet the house

This is high-risk, high-reward stuff, and investors should never invest more than they can afford to lose.


Subscribe to Money Observer magazine

 

Comments

Post new comment

The content of this field is kept private and will not be shown publicly.
By submitting this form, you accept the Mollom privacy policy.