If you have been trading penny stocks for awhile, you probably know that most of them are junk companies. Manipulation, poor business practice, falsified information, and other negativity surrounds the world of penny stocks. That being said, every now and then you can find a gem; a company that defies penny stock stereotypes and positions itself for future success. It can be very easy to get excited about a company like this, especially when you catch on to it before others. The thought of multi-hundred/thousand percent gains can be rather enticing. This feeling of excitement can be further stimulated when you read message boards where other people share your disposition to the stock and start building hype. There’s nothing wrong with that. These are all different elements that make the penny stock markets operate the way they do. But, you don’t want to be a pawn in the penny stock world, do you? If you want to have an advantage, you need to stop thinking like the masses and start seeing what others don’t.
Here are a few of the trades I have made using this strategy:
$1,212profitAMMXLong Stock Still holding more shares long. Just wanted to lock in profits
$2,260profitMYECLong Stock This is one of my fundamental long plays. The company seems like it has a bright future as of now. I locked in profits just in time, considering the price dropped a little over 10% later in the day
So many people love to say that they are long on a stock. “Long and strong man, yeah!” These traders will hold a stock for huge periods of time (at least they say so) because they are convinced that they found the next Microsoft on the ground floor. Don’t be naive. Most penny stocks fail. You need to take advantage of the price action if you want to maximize your profits.
You need to remember these things:
1. You are not indebted to the company. You don’t need to be a “loyal” shareholder. Loyalty is a good trait in the real world, however, it has no place in the world of penny stocks because there is no reciprocation of that loyalty. The company you invest in won’t pay your bills if you lose all of your money in their stock so don’t become a bagholder. Sure, you can brag about how you’ve been holding a stock for over a year, but no one really cares.
2. All stocks fluctuate, but penny stocks are more volatile. It’s important to keep in mind that all stocks go through cycles. Some days they will be up, others they will be down. The difference between penny stocks and big board stocks is that penny stocks are much more volatile. While a big board stock may trade in a +/- 10% range, a penny stock may be up 100% 1 day and down 50% the next. Your investments should not go up and down like a roller coaster because your portfolio will never have any stability. You need to take advantage of a stock’s big moves to keep your investment safe. This doesn’t mean that you don’t believe in the company you are investing in. It means you believe in the company, but recognize that the stock’s movement is not fully in your control or the company’s control. You are accounting for external conditions that affect your stock and taking advantage of them instead of allowing them to sabotage your investment. Some people like to call out “flippers” who constantly buy a stock when it is low and sell it when it is high, but these traders are the ones that keep the stock active. Think about it, if there weren’t flippers, there would just be a bunch of longs holding shares and the stock wouldn’t have any volume. True longs lock up the float so they have their place as well. There are pros and cons to each trading style, but I much prefer swing trading stocks (flipping) to holding for a long period of time and exposing myself to unnecessary risk.
3. The company doesn’t matter; the price action does. Let’s just say you found a company that has the potential to be “the next Microsoft.” Good for you. However, this company is only as valuable as the market perceives it to be. Yesterday (May 15, 2014) a company called MYEC (used in an upcoming example) released some impressive financials. They had a net profit of $1.3 million for the first quarter of 2014 and they are growing at a rapid pace. This is very rare in the world of penny stocks. You’d think the price would have skyrocketed on that news, right? Wrong. The price of the stock actually dropped around 10% following the financials. Clearly, the market didn’t care how “great” the company is. In order to take a holistic approach to your investing, you need to understand both the company and the people trading it. After all, traders/investors are the ones pushing the price up and down.
4. Understand the terrain. Know who you are trading with. Everyone has different trading styles and you need to think about how other people are going to be trading a stock. If you’re long on a stock, you need to understand that there are also scalp traders, swing traders, shorts, etc. Different traders have different styles. So, while someone who is long on a stock may hold it as it goes up a few hundred percent, a swing trader may be happy with quick 50% gains. The assumption that everyone will go long on a stock if the company is good and the price is rising is flawed logic. Not everyone is trying to invest in companies. Understanding this helps you understand price action. If a stock runs 100% in a few days, you can expect that there will be sellers entering the market soon. Using my strategy, you would sell during the run up and buy back when the price dips. You believe in the company but you also understand how the stock trends and, therefore, don’t fall victim to its volatility.
To better understand my strategy, let’s use an example:
MYEC is a prime stock to use as an example to convey this strategy. I first bought into the stock at .0025 because I did some fundamental analysis and actually liked the company. Mentally, I was long on the stock. I believed it had great potential. That being said, I didn’t hold all the way from .0025. I pulled swing trades along the way to limit my risk. This can limit your profit as well, but its important to understand that not all stocks play out the way you want them to. I would sooner take smaller profits than I would expose myself to big potential losses.
Let’s look at longs vs. flippers for a three month time period, assuming all orders were 100,000 shares.
The Long Strategy
Buy 100,000 shares at .0042 on February 18, 2014 for a cost of $420
As of today, May 16, 2014, those shares would be worth $3940 for an unrealized profit of $3520.
Click Image to Enlarge
Keep in mind, that this profit can go up or down at any time. On March 28, 2014, those same shares were valued at $8200. By the end of the year, the shares may be valued at $20,000+ if the stock goes up considerably, or back to $420 if the stock drops back down. There is a lot of uncertainty in this method because you do not know what catalysts will approach during the year. You can definitely make huge gains, but you can also lose a lot of money.
Now, look at a “mentally long” swing trader standpoint on the same 3-month period.
The “Mentally Long” Swing Trader Strategy
A swing trader must be able to spot trends, especially tops and bottoms. Rarely will a swing trader be able to time tops and bottoms perfectly, but you can get close. For this example, I used realistic numbers that were not exact tops and bottoms. They were prices that the stock traded at for a few days, making them feasible entries or exits.
Buy 100,000 shares at .0042 on February 18, 2014 for a cost of $420
The stock shows strength for awhile and you decide to sell at .03/share on March 3 or 4 for a profit of $2580
The stock pulls back down the next few days and you buy 100,000 shares again at .02 on March 5 or 6 for a cost of $2000
The stock runs again but starts pulling back so you sell at .038/share on March 10, 11, or 12 for a profit of $1800
The stock starts bottoming out and you buy back 100,000 shares at .023 on March 17, 18, or 19 for a cost of $2300
Now, the stock is moving again on news and you decide to sell shares at .069/share on either March 26, 27, 28, 31 or April 1 at .069 for a profit of $4300
The stock comes back down and you decide to buy 100,000 sharesagain at .041 on either April 2, 4, or 7 for a cost of $4100.
The stock starts to run and you sell at .059/share on either April 9, 10, or 11 for a profit of $1800.
The stock continues trending down and sideways while losing volume so you don’t place a trade during consolidation
On April 30, the stock drops a bit more and volume is coming in again. You buy 100,000 shareson either April 30 or May 1 at .029 for a cost of $2900
The stock starts gearing up again and you sell those shares at .048/share on May 12, 13, 14, or 15 for a profit of $1900.
Now, we are at present date (May 16, 2014), the stock is trending down and you don’t have a position. You wait to see where the price action goes and you follow it. You are not exposed to any risk because you are not holding shares.
Click Image to Enlarge
Keep in mind that throughout these past 3 months, you have been mentally long on the stock. You never short sell it, but you take advantage of the dips and spikes. You’re never holding shares for too long so you’re risk is minimal and you lock in gains that are used to buy future shares.
So let’s compare the two:
Initially, bought 100,000 shares at .0042 for $420 on February 18, 2014
Has an unrealized gain of $3520 by May 16, 2014.
Still holding 100,000 shares which can increase or decrease in value throughout the year
“Mentally Long” Swing Trader Strategy:
Initially, bought 100,000 shares at .0042 for $420 on February 18, 2014
Swing trades the stock for 3 months and has a realized gain of $12,380 on May 15, 2014.
No longer holding any shares. At this date, the “mentally long” trader is exposed to zero risk and can still buy back in at any time.
Everyone has their own strategy, and if you are making money, you are doing it right. It is not my goal to critique anyone’s strategy because we all trade differently, and, at the end of the day, everyone is just trying to make money. The strategy outlined above is one that works exceptionally well for me. It allows you to minimize your risk and lock in profits along the way. Swing trading like this can limit your risks, however, it can sometimes limit your profits. If you are not holding shares before a strong catalyst is approaching, you may not be able to get your desired entry. That being said, I would rather miss out on profits than succumb to losses. As a long term investor, dips and spikes don’t matter. As seen on the MYEC example, the parabolic spikes in the stock didn’t even affect the true longs because they weren’t selling. I prefer to lock in my gains. Profits mean nothing until you claim them.
Try to focus on this strategy next time you find “the next hot pick.” Know that you can believe in the future of a company and be “mentally long” whilst taking advantage of the dips and spikes in the stock price. This works well for active day/swing traders. If you don’t watch the market every day, this can be much more difficult. My strategy revolves around active trading and I would never invest in a penny stock without watching it constantly; they’re far too volatile.
One of the most difficult things about investing is that it can be difficult to make sense of all of the information available to you. Most companies have an abundance of SEC filings, press releases, and other important documents. Chances are you have read plenty of quarterly reports, financial statements, and company press releases, but do you really know how to interpret these documents?
The documents mean nothing unless you can interpret them properly. That being said, filtering out the proper information is not always easy. I believe that this may be due to the fact that this information is not very relatable. After all, in your daily life, how often do you have to deal with cash flow, assets/liabilities, operating costs, etc.? You may be surprised to find that this information can be very relatable, and therefore understandable, if you know how to think about it properly.
If you are a business owner, you have an advantage. If you are not, you can still make sense of all of this. Every single day, you probably invest in something without even noticing. Just think about the last time you bought an electronic device, such as a smartphone. There are plenty of phones you could have purchased, but you settled on a particular one. You may have been influenced by the price, the value of the phone, the features, the warranty, the customer service, the resale value, etc. The point is that you either consciously or subconsciously thought about what your opinion of the ideal phone was and you analyzed the selection to choose a phone that best suits your needs. Maybe you didn’t buy an iPhone because you perceived it to be a bad value when you compared the cost to the features. Maybe you didn’t buy a Samsung because it didn’t sync well with your other devices. Regardless of the phone you chose, you had a list of criteria you were using to evaluate the product and you found the phone that best matched that criteria.
Investing uses the same framework. You have a list of criteria that you believe make up a good company and you try to find companies that best match those criteria. The thing most people get caught up on is creating the proper list of criteria. Creating this list can be simplified if you can find a better way to organize the information in your head. You should stop thinking of the companies you invest in as mystical entities that are hard to understand. Keep things simple by modifying your thought process. The strategy that works best for me is thinking of public investments in stocks as private investments in companies. This works well for me because I have bought and sold private companies in the past, however, a lot of the strategy is based purely on common sense so anyone can apply this.
Let’s break things down to how you would approach almost any purchase:
1. Is it a good value?
2. Does it fulfill a need of mine?
3. Is it a quality product?
4. Are there better alternatives?
5. Are there any clear red flags?
Let’s run through this thought process on something as simple as going out to eat.
(Yes, I am comparing investing to going out to eat)
Let’s say there is a new steakhouse in town and you are thinking of going.
1. Is it a good value? Are you paying $20/steak or $200/steak? Are the steaks worth what you pay for them? Lower cost doesn’t mean higher value. You get what you pay for.
2. Does it fulfill a need of mine? Am I hungry? Am I in the mood for steak?
3. Is it a quality product? How are the reviews of this restaurant? Do they serve good steaks? Is the restaurant nice? How is the service?
4. Are there better alternatives? Will this new steakhouse be better than the one I usually go to? Can I get a better meal elsewhere?
5. Are there any clear red flags? How is the chef’s reputation? Any cases of food poisioning at this restaurant? Does the restaurant have a good cleanliness rating?
I am well aware of the fact that using the example may seem somewhat ridiculous. Chances are, you don’t read many articles that talk about both stocks and steak. I am trying to make a point here. You make investment decisions subconsciously on a regular basis. These decisions are not difficult because you know exactly what you are looking for. You have a list of criteria branded into your thought process and you utilize that list for easy decision making.
Now, let’s look at this list of questions from the investment standpoint:
1. Is it a good value? How much is a share in the company really worth? If I buy 100,000 shares, how much of the company do I own? What is my money really paying for when I invest in the company?
2. Does it fulfill a need of mine? Does this stock fit my investment strategy? If I want to sell the stock in a year, will it be at the price I want it to? AAPL may be a good value and provide quality product, but they do not match my investment style so I wouldn’t buy and hold shares.
3. Is it a quality product? Is this a good company? How efficiently is it run? Do they sell something that people actually want? What are the chances of this company growing in their competitive industry?
4. Are there better alternatives? Are there any companies in this industry that are doing better/better values? Are there other stocks that are better values? where is my money best spent?
5. Are there any clear red flags? Does the management have a sketchy past? Does the company have a going concern? Are there any lawsuits?
Asking these questions is just the beginning of your research, however, they allow you to approach investing with a similar thought process that you use for making everyday decisions.
Now, let’s get to the good stuff. Let’s look at how you would apply this to a real company.
The goal is to think about companies like a private investment in order to demystify the world of investing.
Here’s a fictional example using an investment into a private company as the basis for comparison. The example is long, so you can skip straight to the lessons if you would like.
Sample Due Diligence Process:
Your friend has been running a restaurant for the past year and has learned that you invest in private companies. He approaches you because he wants you to invest in his company.
Your friend owns 10% of the company and offers you a 10% stake in the company for a $100,000. He believes the company is valued at $1 million so this is a fair deal.
From this one sentence alone, we already have so much information that relates to investing in stocks.
First off $100,000 buys you a 10% stake in the company. This relates to how many outstanding shares a company has. If you buy 100,000 shares in a company, how much of the company do you really own? Well, if the company has 1,000,000 outstanding shares, you own 10% of the company. If the company has 100,000,000 shares outstanding, you only own 0.1% of the company.
First lesson:Look at how many outstanding shares a company has. This determines how valuable each share is.
Another important thing to look at is the fact that your friend owns 10% of the company. This relates to insider ownership of a company. Look at how many shares insiders hold. For this particular example, your friend runs the company and owns 10% of it. He is asking you to buy 10% of the company as well. If the company is so great, why doesn’t your friend have more than a 10% stake in it? Why is he offering you 10% of the company instead of just buying it himself? If the company fails, your friend doesn’t have too much at stake, therefore, he may not be as motivated to make the company succeed. Additionally, this means that 90% of company is available to outsiders. From an economic perspective, supply is high, so price may be lower.
Second Lesson:Look at how many shares insiders own. This can help you see if management truly believes in the company.
Third Lesson: Look at a stock’s float. The float is the amount of shares available on the public market to be traded freely by traders and investors. The lower the float (supply), the higher the demand can be. Higher demand for a stock can allow the stock price to rise faster. This is why a lot of traders go out of their way to find low float stocks. Imagine a stock trades at $0.03/share and you want 100,000 shares. If the float is 500,000,000 shares, it may be pretty easy to get your shares at the desired price. If the float is only 1,000,000 shares, it would be harder to get 100,000 shares at $0.03/share without driving the price up. The lower supply of low float stocks means that demand for the stock can push the price up much faster as investors are “fighting” to get the shares they want.
The last piece of data available in the sentence above is that the company is valued at $1 million. Well, who decided this? Is this valuation fair? This relates to a stock’s market cap. The market cap is the number of outstanding shares multiplied by the share price of a stock. If a company has 1,000,000 outstanding shares valued at $1 each, the market cap is $1 million. The market cap is the company’s valuation as determined by the trading activity. A lot of investors will ignore this metric when placing trades, however, it is important to look at if you are actually investing in a company because this allows you to determine if a company is over valued or undervalued. You want to find undervalued companies.
Fourth Lesson:Look at the market cap to see a company’s valuation. Decide whether you believe it to be overvalued or undervalued.
Let’s move on with the example to help you understand how to value a company.
Being a diligent investor, you want to know more about your friend’s business. How much money do they make? Do they have a lot of liquid assets? What kind of liabilities do they have? Your friend tells you that their restuarant brings in revenues of $500,000 every year, $100,000 of which is profit. They have assets such as their restaurant’s equipment, their building, and some cash in the bank. The equipment is valued at $100,000, the property is valued at $100,000 and the company also has $100,000 in cash for a total of $300,000 in assets. The company is also paying off a $500,000 loan and they still owe their employees $50,000 in wages for a total of $550,000 in liabilities.
This brings up a few things you need to look at. First off, the company makes $500,000 in revenues but they only keep $100,000 of those. As a diligent investor, you wonder where the other $400,000 is going. Is that the cost of food? Is that the cost of paying management and staff? Knowing these things would help you determine how efficiently the company is being run. If the restaurant is spending $100,000/year on their floor manager’s salary, you may decide that the company is being run inefficiently. You can look at a company’s Cash Flow Statement or Income Statement to track expenses and revenues.
Fifth Lesson:Look at a company’s financial statements to see what is “under the hood.” Think about how money is being spent. Is the company getting the best prices on their inventory (Cost of Good Sold). Is the company paying their management team too much (Selling, General, Administrative costs)? Don’t let this part of a company’s financial statement confuse you, as it is very basic. Think about this: If you were trading stocks and made $500,000 on the year but had to spend $450,000 to do so, would you be trading efficiently? Sure, you made $50,000 on the year, but why the hell did you have to spend $450,000 to do so? Apply the same logic to how a company manages their money.
The next important thing to look at is how much your friend’s company owns and how much they owe. This relates to assets and liabilities. Your friends restaurant owns $300,000 worth of assets and owes $550,000 to other people. This means they have net tangible assets of ($250,000), meaning they owe much more than they own. Clearly this is not a good thing. Someone may own a Lamborghini valued at $200,000, but if they have $300,000 in outstanding credit card bills related to the purchase, they really aren’t too well off. You wouldn’t consider that person to be good at handling money, would you? Apply this same logic to a company you invest in. This shows how responsible a company is when it comes to managing money.
Sixth Lesson:Always look at a company’s assets and liabilities. This will help you gauge how much the company owns compared to how much they owe. Essentially, it is the company’s net worth. Look at a company’s net tangible assets to see if they own more than they owe, or vice versa. Don’t treat all assets and liabilities the same. Make sure you understand what they are. For example, a company may have $1.3 million in assets, however, if you look closer you may see that $1 million of those assets is intellectual property. $1 million in intellectual property is worth far less than $1 million in cash. A lot of penny stock companies get tricky/sneaky in this part of their financials so be careful.
Let’s move on with the due diligence.
Your friend’s restaurant has only been open for a year. You understand that it may not be the best idea to base your decision off of only one year of data so you dig deeper. You ask your friend to see monthly financial reports so you can see if the company is growing. Your friend shows you the reports and you see that revenues are growing by 5% each quarter, liabilities are growing at a rate of 10% each, and assets are decreasing at a rate of 5% each quarter.
First things first, you see that the company is bringing in more money each quarter (revenues). This is good. It means the business is growing and more customers are taking an interest in the restaurant. That being said, the company is growing their liabilities (things they owe) much faster than revenues are increasing (10% vs. 5%). Additionally, the restaurant’s assets (things they own) are dwindling at the same rate the revenues are increasing (5%). This means the revenue growth really is not too impressive.
Seventh Lesson:Look at a company’s growth rate from multiple perspectives. Look at revenues, profit margins, assets, liabilities, etc. A company may be able to increase revenues by 100%, but if they have to take out a loan to fund a massive marketing campaign, that may not be too impressive. Let the numbers talk. A company’s growth rate should be looked at holistically. Ask yourself this: is the company getting more or less valuable each quarter? This requires that you look at the company as a whole and interpret the financial statements at a core business level. Revenues may be decreasing or flatlining, but profit margin and assets may be increasing. This would tell you that the demand for the company’s products may be decreasing or flatlining, but the company is running more efficiently internally. Contrarily, the revenues may be increasing while the profit margin decreases and liabilities increase. This would show you that the company is stimulating demand for a product, but they are not scaling up their business model efficiently. In short, think about growth holistically in order to understand what direction the company is moving in.
By now, you have seen a lot of the numbers, but you want to better understand some other elements of the business. You ask your friend if there have been any problems at the restaurant? He mentions that their Yelp page has an average rating of 2-stars, their employee turnover is very high, and some new competing restaurants just popped up in the neighborhood. You proceed to ask him who is running the restaurant and what their plans are for the future. Your friend gives you a list of the key players in the restaurant and let’s you know that the restaurant plans to start franchising in the upcoming year in order to increase profits.
By asking your friend about some of the problems in the restaurant, you learn about the risk associated with your investment. The restaurant has a bad reputation based on online reviews, employee retention is high so their may be an internal management problem, and competition is increasing which may create a going concern. You know know about the business’s weaknesses and the factors that may threaten their existence. This leads to 2 important points.
Eighth Lesson:Look for red flags. Dissect a company’s business and see what you need to be worried about in the future. Any negative catalysts that may be approaching can put your investment at risk. You need to know about these.
Ninth Lesson:Look at competition. A company may be doing well, but there may be another company doing much better. Which would you prefer to invest in? Strong competition threatens a company’s existence. Analyze their competition to understand 2 things. 1) Is there a going concern for this company? 2) Is there a better company I can invest in?
The next question you asked your friend was about who was running the company. A business is only as good as the people running it. If you looked into your friend’s restaurant and found out that their management has a sketchy past and a history of running failed companies, you would probably avoid the investment.
Tenth Lesson:Look at a company’s management. Understand who is running the company and decide whether or not you think they are capable of making it succeed. Every decision a company makes is made my a person. If you know who these people are, you can gain some foresight into the company’s future direction.
Lastly, you asked your friend about plans for the future. Your friend mentioned that they want to franchise the company to increase profits. This could be huge if done effectively. You now know that a positive catalyst is coming and this may make the company more valuable.
Eleventh Lesson:Look at a company’s future plans and see if any positive catalysts are expected. A company may be decent based on their current performance, but a huge deal may be in the works that will take the company to a new level. Know what is expected so you can make a good long term investment.
Summarizing this example:
Here are the facts you collected from the analysis:
Your friend offers you a 10% stake in his restaurant for $100,000.
Your friend also owns 10% of the company
The company is valued at $1 million.
The company brings in $500,000/year (revenues) and keeps $100,000 (net income).
The company has $300,000 in assets and $550,000 in liabilities for a total of ($250,000) net tangible assets.
The company is exposed to risks such as poor customer reviews, high employee turnover, and increased competition.
The company has positive catalysts such as plans to franchise to increase future profits.
Revenue is growing at 5% while assets dwindle at the same rate (5%) and liabilities increase 10% each quarter.
So, Would you invest in this company?
Helpful Tip: Remove the extra zero’s from a company’s financials so they can be easier to understand. You may not be able to internalize the concept of paying $100,000 for a company that brings in $500,000 in revenues, but you may be able to fathom the idea of paying $100 for a company that brings in $500/year.
Personally, I would not invest in this fictional company for the following reasons:
Your friend, the owner, only has a 10% stake in the company. This doesn’t show much faith in the company’s future.
The company owes more than they own (net tangible assets). This means the company has a negative net worth. Why pay money for something that has a negative value?
Revenue is growing at a minimal rate, but liabilities are increasing twice as fast. The company is spending much more than they bring in. How are they going to be profitable like this?
The company is valued at $1 million. This seems like an overvaluation. They only bring in $100,000 year and they owe a lot of money. Let’s say I were to get 10% of the profits for my 10% investment in the company. That would mean I would make $10,000/year so it would take 10 years to break even on my investment, let alone make a profit. Additionally, this assumes that revenues do not decrease over the years. It also fails to account for the fact that liabilities need to be paid. The chances of me making a profit in the next 10 years are very slim.
Their are a lot of threats to the company’s existence. The negative Yelp reviews show that the product is not that great. The increased competition shows that their is a lower barrier-to-entry for this industry and making a profit is only going to become more difficult. Employee turnover is high meaning that management does not know how to keep their employees happy.
Sure, a franchising plan is in the works, but the company hasn’t even made their current business model successful yet. How are they going to make a new one successful?
All of these numbers are made up and the analysis was not very in-depth, however, it is meant to serve a point. The main point of this entire article is to think about what every number means and how you can relate that to thought processes you already use. This helps you understand what exactly you are investing in. When you hear statements such as “The company brought in $1.8 million in revenues during the first quarter?” does it mean anything to you? No, that can mean anything. You need to put it in context in order to understand whether this is truly a good investment.
Make investments in public companies relatable to your daily life. Everyone can take different approaches to this based on how their brains work, however, the end goal is the same: demystifying investing.
Someone else may read the example above and decide that it looks like a good investment even though I didn’t. That is 100% okay. Everyone has a different investing style so everyone will want to invest in different companies. The goal is not to make the same decision as the majority of people; it’s to understand what you are analyzing. You need to be able to make sense of the abundance of data you have access to. If you can do that, you are ready to start investing.
Trying to find good companies in the world of penny stocks is no easy task. Most of the companies are complete junk, as reflected by their share prices. That being said, there are some diamonds in the rough. It’s important to look at how a company operates their business in order to understand where they are headed. Sure, some people only care about charts and technical indicators, however, if you want to find some solid companies that you actually believe in, you must also focus on a company’s fundamentals. After all, it’s the people behind a company that will make or break its success. This article is geared towards people who invest in companies and don’t just trade them.
There are so many penny stock companies trading on the public markets so every investor has the luxury of being able to choose which companies they want to support. Remember, it is your choice as to whether or not you want to exercise your right to that luxury. If you cannot find any good companies, you do not need to buy anything. You’re never forced into buying a bad company. Be careful of buying into the hype and believing a company’s story. You need to be critical of everything and you need to be meticulous with your research.
A lot of people fool themselves into believing that penny stocks are companies in growth stages, and, therefore these companies do not need to be held to the same standards of other companies because they are just starting off. That theory is partially valid and partially flawed. Penny stocks are companies in growth stages, however, that does not excuse them from failing to meet average business standards. There are certain bare essentials that every company should have. As an owner of a few businesses, I always look for these things. I could start a company tomorrow with limited funding and take care of most of them, so a company who is receiving a lot of money from the public should be able to do the same.
Here are the bare essentials:
A Professional Website and Web Presence – In this day and age, if you do not have a website, you are a laggard: simple as that. There is absolutely no excuse for not having a website in this era of business. Websites can be done in-house by those with the proper skills or outsourced to the appropriate parties. Websites are relatively inexpensive nowadays as well. You can get a professional looking website designed for around $2,000-$10,000 depending on your company’s needs and resources. Sometimes, you can even get a site designed for cheaper (or free if you have the skills to do it yourself). A company website is a digital representation of a business and everything it stands for. Websites provide an opportunity for companies to present themselves as they wish to be seen. This gives investors a credible source for gaining insight into a company. Investors can learn about a company straight from the source instead of relying on 3rd party information that can be false, misleading, or damaging to a company. Of course, having a website is not just about “having” a website. A website is a tool and it should be used properly. This means that the website should look professional, provide all necessary information to investors, and build a strong brand identity. Additionally, a company should make sure that their website can be found. If an investor Google’s a company’s name, they should be able to get to the website right away. If you’re website is not up to par or can’t be found, it is a bad reflection on your company.
In short, a business should have a professional website and make sure it depicts the company as it wishes to be seen.
Revenues – Businesses are designed to make money. The only way to do that is by…you guessed it…actually making money! Revenues are essential for most real companies. There are some exceptions to this, such as biotech companies, however, most other companies should be making money. At the very least, a company should not be accumulating debt before they are making money. You can approach this on a case-by-case basis to analyze whether or not you think the company should be making money yet, however, you shouldn’t be lenient with your analysis. Revenue generation is not very difficult. Maintaining a positive net income can take time, however, revenues are the main source of cash flow and should be a priority for any company. This is huge for companies that sell tangible products. If you have tangible products, you need to have revenues or else you have failed at your business plan. If a company cannot even sell their product, you have to wonder how skilled the management team really is. I’m not saying that every company needs to be bringing in millions of dollars right away, but you should focus on how many of their products are actually being sold. For example, if a company sells e-cigarettes (a growing industry) to generate revenues, you will want to see that they are selling enough units to prove that they may have potential for growth. If their quarterly revenue is $2000 and each e-cigarette sells for $50, you can conclude that the company sold 40 units. That’s not very impressive at all. Don’t you think you could sell 40 e-cigarettes on your own in 3 months if it was your only job and you were given funds to support your efforts? Great products mean nothing in the hyper-competitive business markets. The companies with solid sales skills are the ones that will last. Additionally, you should see how much cash a company has saved up. A lot of penny stocks only have a few thousand or a few hundred dollars in the bank. That’s embarrassing. A multimillion dollar company shouldn’t have less money than most people have in their personal bank account. Remember, when investors buy stock, they are giving the company money to finance their business activities. How well the company handles this money says a lot about them.
In short, real businesses make money and manage their finances appropriately.
Investor Relations/Updates – When a small penny stock company decides to go public, they are essentially asking a favor from investors. They are asking that investors believe in the company’s business model and provide financing to help them grow. In order for this setup to work, there needs to be reciprocation. The company who asks for money is now indebted to these investors (not legally, but for the sake of maintaining the relationship). This means that the company needs to update investors on the company’s operations. Think about it, if you lent a friend a good sum of money to start a business, wouldn’t you want some updates as to how the money is being spent? I know I would. It’s the only way to know that your money is going to good use. A company doesn’t need an entire investor relations department, however, they need a plan to keep investors updated. The business world is fast-paced and any solid company in a growth phase should have updates on a regular basis. These updates, positive or negative, need to be shared with investors. It’s easy enough to put out frequent press releases to keep your investors happy. After all, investors are the ones financing a company’s operations. There’s no need to distribute a bunch of “fluff” news that has no meaning, however, if a company can’t come up with important updates on a regular basis, there is a good chance that they are not growing as fast as they should be. Different companies will produce updates at different paces, so it’s up to you to decide if the updates are sufficient, however, if a company doesn’t update its shareholders at least once a month, I would stay away from them.
In short, a company should keep investors updates so that investors know what their money is being used for.
Business Focus/Core Competencies – When investing in a company, it’s important to know about their core business model. You should know the company’s plan and where they currently stand in their industry. This allows you to analyze the company from a business perspective. For example, if a company produces office equipment, you should hone in on every aspect of their strategy. How do they differentiate themselves? Do they have better supplier for higher profit margins? Is there a higher demand for their products over others? How many competitors do they have? Where do they stand when compared to the competition? Are they in a profitable industry? Asking these kinds of questions helps you understand the long term sustainability of a company’s business model. A solid company should know their core competencies and make them known to the public. Some companies are innovators, some companies are price leaders, some companies dominate international markets, etc. There are a lot of gaps in the markets so a company should know where they stand and have a solid plan for the future. When you see companies who try to “diversify” by entering many different industries, you can assume there is a lack of focus within their business. This became very apparent during the marijuana stock boom as all different types of companies, from aviation to surf gear, tried to position themselves in the marijuana industry. Good businesses (like good traders) know what they are good at and they stick to it.
In short, make sure you know exactly what a company does and how effective they are at doing it.
A solid management team – Having a solid management team is crucial to the success of a company. A company is only as good as the people running it. There is a reason why certain individuals are known for consistently creating successful companies. For example, if Mark Cuban backs a company, you may assume that there’s a good chance it will be successful. It is important to learn who is running a company because they control everything that the company does. Look at who the key players are within a company and do some research on them. Are they a reputed individual? Do they have a track record of success? Do they have any skeletons in their closet? Answering these questions helps you understand how a company is run and may also make you more confident in the direction a company is headed. Think about it, if someone you didn’t know asked you to invest in their company, would you? Hopefully you answered, “no.” You wouldn’t trust a stranger to handle your hard earned money. Apply that same logic with penny stocks and you will be better off.
In short, know who the key players are in a company and learn their history so you know who is handling your investment.
A Marketing Plan – As mentioned multiple times throughout this article, a company’s product does not matter. So many people forget that. Think about how many great products are out there (and those are just the ones you know of). I could have the next greatest invention sitting right next to me right now, but that wouldn’t matter if the masses didn’t know what it was, how it will help them, and how they can get it. For a company to be successful, they need a solid marketing plan. This plan dictates how a company will actually sell their product and start profiting, which, of course, is the basis for any solid business. Marketing has changed a lot in the past decade, and small start up companies can now compete with larger, well-established companies. Just look at a company like Dollar Shave Club (not public). They produced a viral video and now they’re giving bigger razor companies a run for their money. Marketing doesn’t need to be expensive. Creativity and innovation go a lot farther than big budgets these days. As a business owner and digital marketer, I see this first hand. Not every business is going to market their products the same way and not all businesses will need the same amount of marketing. That being said, a quality marketing plan is crucial and says a lot about a company’s management team.
In short, every business needs to have a plan for how they are going to get their products into the hands of the consumers they are targeting.
These are a few things that can be the difference between a good company and a great company.
Social Media Pages – Social media is huge for businesses. If you need convincing of that, go do some research. Companies that find a way to utilize social media effectively will have an advantage over their competition. Similar to a website, the key here is doing things “right.” Utilizing social media just for the sake of it is a waste of time.
Stock Volume and Value– A good penny stock company will realize that there stock is actually a product in itself. After all, the company is trying to sell shares to investors. A solid company will realize that they need to catch the attention of investors if they ever want to grow their company. I have traded a lot of great companies that never reach their fair value due to a lack of volume. Trading volume reflects investors’ interest in a company. This relates to the marketing plan mentioned above. Having the greatest company in the world means nothing unless investors are aware of/interested in it. This doesn’t mean that a company should go pay for promotions or engage in other shady tactics, however, they should be trying to get the attention of investors. Chances are, if the company does everything mentioned above, the stock volume will come naturally, but if it doesn’t, a new plan may need to be formulated.
Consistency – Public companies shouldn’t be unpredictable. Investors don’t want to put their money into a company that isn’t consistent. Consistency contributes to transparency, and can improve investors’ confidence in a company. Of course, a company will always encounter surprises, however, those surprises should be related to uncontrollable external conditions, which is normal. When I refer to consistency, I am talking about how a company handles themselves. If you create a habit of putting out a press release twice a month, you should remain consistent. If you create a social media page to communicate with your investors, you should be consistent in your post frequency and responses. When a company stops doing something that investors expect them to do, it can worry investors and the share price will be affected accordingly.
Noticeable Growth – Investors want to see growth of a stock’s share price and growth of the actual business. The two are correlated. If a stock price shoots up 100% and the company reports negative business growth, investors will be skeptical. Penny stock investors base a large part of their strategy around finding growing companies at the ground floor. After all, why else would anyone buy and hold a sub-penny stock? Companies need to make sure they are growing at a rate that will satisfy investors. This can be anything from expanding a management team, extending product lines, or simply selling more product. Growth doesn’t always have to be in the financials, however, a company’s growth should be noticeable. If you gave someone millions of dollars to start a brand new company (similar to how investors give their money to penny stock companies), wouldn’t you expect them to be making noticeable progress on a regular basis? If they weren’t, you would probably be upset. You should apply the same logic to the companies you invest in.
You would think that most traders would be extremely cynical of the companies they trade: cautious, at the very least. It’s so easy to get burned in the world of penny stocks that cynicism and harsh critique become somewhat of a self defense mechanism. This just isn’t the case with some traders. Time and time again I see people putting way too much faith in the CEO’s of penny stock companies. STOP! That is a terrible strategy that will only harm you in the long run.
Chances are, if you are reading this, you are a diligent investor/trader and this post does not apply to you. That being said, it is still something you may want to look out for, as there is another aspect to it that you can benefit from. I’ll discuss this towards the end of the article.
First things first, there’s no problem trusting a company you invest in. In fact, if you are truly “investing” in a company, you better believe in their CEO and management team. Trusting in someone such as the late Steve Jobs makes sense. The man has a proven track record and a vision that has made Apple the highest valued publicly traded company in the world. He has already proven himself and you can form an opinion accordingly. Of course, you should never be blindly led by faith, however, you do not need to be so cynical that you don’t trust anyone; that is not the point of this post.
That being said, “investing” in penny stocks is extremely dangerous, but that’s a whole different argument. You should be wary about every move the CEO does or does not make. I don’t care how many times the CEO was on TV, featured on a prominent website, or how many other companies they have run. The stock charts and company fundamentals speak for themselves.
Far too many times I see a stock tanking and people say things like “Who cares if the stock is down 50% today? “Insert CEO’s name here” has a plan. Just watch.” or “Buy the cheap shares while you can. “Insert CEO’s name here” is going to burn the shorts soon.” People are literally idolizing CEO’s they haven’t even met. I don’t want to mention any specific company names because it’s not my intention to call people out in this post, but this happens all of the time. People put their faith in the CEO and hold a stock as it tanks exponentially. I was guilty of this when I started trading penny stocks but I learned fast. Getting burned by bad companies will brand some important lessons in your head.
Think about it. Why would you ever leave your investment in the hands of someone else? If a stock is turning against you, get out. Do you think the CEO really cares if you lose your money? Do you think the CEO started a public company so they could help other people get rich? Don’t be naive. The CEO is doing what everyone else is: trying to make money for himself. The difference is that a lot of these CEO’s get paid a salary either way. Of course some of them are large shareholders, which is a plus because they profit on positive performance, however, there is still no reason to idolize them. You don’t even know the CEO. They might be a great business man or simply a great manipulator/self-promoter. Always be cautious.
Analyze the company and substantial facts. If the CEO is doing a good job, that’s great! It’s his job to run a profitable company. If the CEO is doing poorly, recognize that and reconsider your investment/trade. There is a reason so many penny stocks fail.
Profiting from the Situation
Hopefully, by now, my point is clear; do not put your faith in a penny stock company’s CEO. It’s as simple as that. All of that being said, there is a way you can take advantage of the fact that some people do put their faith in the CEO of a company.
When people truly trust the CEO of a company, they will hold the stock for a long time. It’s something I would never do, but it works for some people. These people lock up the float and make it easier for the stock to run up and down. If you are aware of this, you can profit from it.
Additionally, when people put their faith in a CEO, a stock tends to move more on news and updates. I’ve seen stocks shoot up in price from a simple tweet or Facebook post by a company CEO. Once again, if you are aware of this, you can profit from it.
Always be cautious when dealing with penny stock companies. Try to see what others don’t so you can have a competitive edge in the market.
If you have invested some time into your trading education, you have probably learned a lot about trading rules. Every trader has a set of trading rules that will make or break them. I always hear traders talking about how important it is to never break your trading rules. First things first, I agree with this. Trading requires discipline and you should always stick to your plan. That being said, you need to make sure your trading rules match your trading style. Trading sub-penny stocks is a lot different than trading small/large cap stocks on bigger boards, therefore, you need to adjust your strategy accordingly.
One of the biggest rules most trader’s have is to cut losses quickly. While I agree with this rule for higher priced stocks ($0.50+/share), I have found that following this rule causes me to lose more money in sub-penny stocks. For higher priced penny stocks ($0.50-$5/share), I try to cut losses at 5-10%. These stocks are usually less volatile, so a downward movement of 5-10% indicates that a bad trade was placed and the stock is moving against you. This is a great rule to follow when you want to protect yourself in these types of trade, however, this rule can actually hurt your bottom line with sub penny stocks.
Sub-penny stocks are much more volatile, so 5-10% moves can actually be normal fluctuation, quick dips, or even consolidation. For that reason, I rarely scalp sub-penny stocks. I’ve found that most of the money is in swing trading sub-penny stocks. Therefore, you need to be able to stomach unrealized losses without panicking. After all, you probably got into the stock for a reason. Of course, if the stock is really moving against you, you should cut losses, however, it is important to understand why the stock is moving the way it is. When I enter a swing trade on a sub-penny stock, I have a very specific plan. I usually want to get in when I believe the share price is undervalued and sell when I believe it is overvalued. Often times, I will be waiting for a specific catalyst to trigger my sell order. While I wait, the stock fluctuates a lot.
Here is an example. I was down about $1700 on a MYEC trade before selling the stock later for a profit of about $5100. I bought my shares at .0224/share on March 6, 2014. That same day, the price dropped down to .0194/share. At one point during the day, I was down about 14% or $1700 on my 570,000 shares. Trading rules would have told me to cut my losses way earlier, but my plan was different. I knew the company had some big catalysts approaching so I held. Luckily, my plan played out the way I wanted it to and I made a nice $5100 profit.
I could give plenty of examples as to why you should be using different strategies for sub-penny and cheap penny stocks, but the point is simple. Most traders stay the hell away from sub-penny stocks so there rules do not apply. Stocks under $0.05/share are exceptionally volatile and risky. If you enter them, you need the right strategy. Normal trading rules won’t help too much. Technical indicators are not as effective, support and resistance can be broken down easily, and daily price ranges are much wider than with other stocks. In another post, I talk about how you should never invest what you cannot afford to lose. I’ve lost as much as 90% of my investment on sub-penny trades gone wrong, however, my rationale behind those trades was garbage.
In short, make sure you have solid rationale behind your trades, and keep in mind that you may need to ignore some widely accepted rules in order to come out on top in the long run.
As a day trader, you see a lot of stocks on a daily basis. It is easy to focus on the present movement of a stock and forget that it has a long history. Of course, you analyze charts from multiple time frames, however, this is sometimes not as insightful as it should be. While it wouldn’t be efficient to learn the back story of every single stock you trade, there are certain times when it is appropriate. The first one being for sub-penny stocks or anything under $0.05 trading on low volume.
Sub-penny stock movement confuses a lot of people because they don’t know what drives it. While there are obviously a lot of factors driving the price movement, there is usually one that overpowers them all: the story. If you’ve traded sub-penny stocks before, you must be familiar with “the story.” Every stock has one. It either goes something like “This company is garbage and we are waiting for them to fail” or “This is the next Microsoft. Millionaires in the making here..” 90% of the time, a stock’s back story is as unsubstantiated as this statistic. That doesn’t matter though. What matters is that people tell themselves a story and trade accordingly. Additionally, other people are influenced by the stories of others, which affects price action as well. Read my post on market sentiment to learn more. Learning these stories can help you understand why a stock’s seemingly random movement is actually not random at all. Sometimes movements can be triggered by a post on a message board, a social media update from the company, or an expected news event that was announced months ago. It can be hard to understand this story simply by looking at the press release history, especially if you are looking for recent news. Sometimes a press release may seem like good news, but a stock’s story can disprove that theory or solidify it even further.
Another time you will want to know the back story of a stock is when it is moving upward exponentially. Sometimes this can be due to a pump and dump scheme, positive news, or some other factor, however, learning a stock’s history can tell a lot.
Let me use a simple example to support my point. Last week, I did a post on a stock called HDY because it had a perfect intraday technical breakout. What I missed was that the press release that triggered the breakout was more important from a fundamental standpoint than I expected.
Let’s look at the HDY daily chart real quick:
Notice anything that seems important? How about the huge drop on March 12, 2014? There’s also the huge breakout on May 5, 2014. Could the two be related? Well, obviously that is my point.
Now, if you were new to this stock, as I was, this news may not seem like a big deal. After all, I barely remembered what a Force Majeure was from my previous law classes so I did not expect the stock to run. Doing some basic research on the history of the stock would have told you that this was a huge event. The story on May 5, 2014 practically filled the entire gap caused from the gap down on March 12, 2014. This movement makes sense, however, HDY jumped almost 200% on May 5, 2014 so the move didn’t seem very sustainable.
So, How do you incorporate this into your trading strategy?
Always take a holistic approach to your trading. Take all factors into account. Think about who is currently invested in the stock, who has the stock on their watchlist, what major catalysts can move a stock, etc. Charts are useless if you do not use them to tell a story. Try to think about a stock like a real business. If you were buying a real business, you would want to know all of the details. If the business’s value dropped considerably at one point, you would want to know why. You would also want to know who the customers of the business are (shareholders for this analogy). You would want to know about all current issues the business faces.
Don’t get me wrong, the majority of the time I trade, I don’t do this. I make trades off of the charts and don’t think twice about what a company does. That being said, I try to make my strategy as holistic as possible. When I see a big mover that is worth my time, I do fundamental research. You can never know too much about the stock. This is a whole different strategy from technical trading. I don’t only trade technical setups. In fact, some of my most profitable trades have been from learning a company’s story and placing trades accordingly. Keep in mind that knowing a story is different then believing a story. You want to know the story so you can understand how other traders are thinking. You do not want to believe the story as you will fall victim to the same thought process of the majority of investors, which can cause you to lose your competitive edge.
As always, do not take my trading tips as concrete strategies that should be implemented into every trade. Use these tips as tools and use them when they are necessary. I use different strategies for different trades, however, I like having a full toolkit at all times.