The phrase “penny stock” tends to scare many investors away. But, those are the companies you read about that returned triple and even quadruple-digit returns.

Penny stocks are usually small and newly created companies. While still trying to get established, penny stocks are analogically infants and toddlers compared to large-cap adult companies. With great parental guidance from a superb managing team, penny stocks can hold a promising future.

But, as with all children, they occasionally run amok. Some fall into the financial hole and can’t get out. Others have great balance sheets but no growth strategy. So, how do you find one that is ready to mature?

Do your research! Get background information. There may not be an abundance of information on the company because of lack of media attention. So research patiently and vigilantly.

Check if the managing executives and board members are respectable and passionate towards the company. A positive staff is always going to produce great work and show that through the company’s bottom line.

With these small companies, you might even have a chance to talk to executives and directors. Give them a call, and see what kind of response you get.

Make sure the company is in a growth position and if they are compatible with future trends and markets. A company’s willingness and desire to expand is a good indication of the value of a company.

Another good way to analyze a company is by reviewing a company’s financial reports and accounting sheets. 10-K annual reports are a great source to attain information. Comparing and analyzing numbers throughout the years will show the “guts” of a company that you won’t read or hear about in the news. However this process can be challenging…

In compliance with SEC rules, companies have to report their financial records. Inside executives know that these records are easily accessible and can show the value and worth of the company. As a loophole, firms will try to format the reports differently every year to make the evaluation more difficult and tedious to analyze.

Be sure to take your time analyzing everything. If a company continues to throw obstacles in its reporting, that might be an indicator to stay away.

Another important task before investing in a penny stock is to analyze the industry it’s in. Small-caps, in general, get tossed around both up and down more than their larger counterparts. If you are looking at a junior precious metals miner, take a look at what the large miners are up to.

Also, make sure you study what, if anything, the underlying asset of the company is doing. Using the junior miner as an example, make sure you are comfortable with the direction the metal the company is mining is going. If you don’t think gold will continue to rise, you probably shouldn’t invest in a gold miner.

Another important factor you should look at is market share. Obviously, most penny stocks don’t control a large share of their market. But make sure the company you are looking at has a strategy for that. And if it doesn’t, make sure that the industry is growing fast enough to create an opening for the company.

The best way to invest in penny stocks is to find niche companies. Usually, large companies leave areas open that just aren’t worth the hassle for the blue chip to fill. That may be the perfect place to build a smaller company. Make sure that niche has enough room to grow in before you invest.

It takes plenty of time and effort to go through all of these important tasks, but the end result is worth it.

Regards,
Mark Louie
September 4, 2008

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

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