First, let’s break down exactly what I’m talking about…

Penny stocks offer the largest potential of capital gains. I’ve said this before, but it’s so true: It’s much easier for a $50 million company to turn into a $100 million one, than it is for a $50 billion company to turn into a $100 billion one. But on top of capital gains like this, you can also enjoy the same benefits that the blue chips provide…namely, dividends. I’ll show you how…

Turn $5K into $151,025.76 in Just Five Years

The year was 2003. Fertilizer maker Terra Nitrogen Company (TNH: NYSE) paid a small dividend about 4-5% of its share price, which was only $4.40. Nothing to write home about. But, it was picking up steam.

Just $5,000 would have bought you 1,136 shares. But starting the next year, the company took off. The demand for its products grew sky high, and so did the company’s dividend plan. Those 1,136 shares would have been paid off through the company’s dividends in just two and a half years.

So you would have had free shares of a growing company that pays a tremendous dividend. But here’s where the story gets good. Over the next two and a half years, the company absolutely soared. You would have received dividend checks totaling $20,686.56 with just a $5,000 initial investment a few years before. And it’s still paying dividends to this day.

On top of this, the company’s share price skyrocketed. Shares of Terra Nitrogen went from trading at less than $5 to $110 today. That’s a 2,400% capital gain, which is a complete bonus. After just $5,000 upfront five years ago, you’d be sitting on $151,025.76 right now:

That’s great, but how do you look for this kind of thing? Well, that’s the hard part.

Finding the Best Penny Income Plays

One way to go about it is to start with a simple stock screen. A couple of key items to screen for would be dividend yields, dividend growth, cash flow, and debt. Here’s how that works…

Obviously, the company needs to pay a dividend for it to be an “income” play. While most people will tell you that you need to find high dividend yielding stocks, I disagree. The growth is the only thing that matters. I look for yields around 3%-6% — solid but not too large — and dividend growth over 5%-10% per year. This gives a strong dividend position.

Second, you’ll have to make sure the company is making enough to continue to payout dividends. If the company is just piling on debt to appease income investors, forget it. That’s robbing Peter to pay Paul. You don’t need that. That’s why you have to look at the company’s income and current debt levels.

Once you narrow that search down, you can plug in any other criteria you might have, like a share price under $10 or a market cap under $1.5 billion — to make sure you are only looking at penny stocks.

Once you find a few company’s to look at, you’ll need a checklist to determine if these companies are actually worth buying:

1. Does the company have plenty of cash on hand?
2. Is the company’s operating cash flow minus capital expenses sufficient for future dividend payments? (Three times current dividend is a safe bet.)
3. Is the company’s business safe from competition?
4. Is the company’s product or service recession proof?
5. Would you be willing to sink an investment in this company and leave it for a few years?

If you answer yes to these questions, you might have found a winner…

Lastly — and most importantly — you’ll need to look at the company’s future prospects. If a company isn’t going to grow much more, or bring in any more income than it did in the past, there’s no way it can grow its dividend without maxing out at some point. You must make sure the company and its industry are on track to continue to grow.

Take the Terra Nitrogen example again… If you had predicted the ethanol boom coming, you would have been able to spot the need for fertilizer. After all, it takes a ton of fertilizer to grow corn. Foresight like that, even if it’s just a few times, can leave an average investor with a large retirement account, along with big dividend checks for life.

While we continue to scour the penny stock market, we’ll keep you informed if any penny income plays pop up. That just might be your best bet to grow your retirement with just a few bucks…

Sincerely,
Jim Nelson
August 25, 2008

Investing in Penny Income Stocks was originally featured in the Penny Sleuth.