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Joseph Krueger
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Disclaimer: This blog is an expression of my opinion on a particular company or matter. I am not a financial advisor or professional analyst. This is not a solicitation to trade any security. Although I rely on company approved public documents and make all reasonable efforts to confirm the... More
  • Part 2 of Penny Stocks or Penny Slots: When to buy, hold, or sell a penny stock 1 comment
    Nov 7, 2009 8:42 PM
    Entering the often treacherous waters of penny stocks requires more careful due diligence to avoid getting caught in the various pitfalls of penny stocks, as I discussed in part 1 of this article. The key question to ask yourself before even considering a penny stock is to ask yourself the most obvious (but seemingly most overlooked) question: Why is the stock a just a few pennies? To briefly summarize this from part one, here are the three primary reasons below:
    1)      The company is not viable.
    2)      The shares have been diluted.
    3)      The company is a scam or is cheating shareholders.
     
    It is also important to remember that the criteria for investing in penny stocks are different than the stock in larger companies, as most penny stock companies are in the development stage, and you are investing in the potential future of the company, not the current status of the company.  Assuming you have considered why a penny stock is only in the pennies (or less), and are comfortable with the reasoning, then you are ready to perform the research (due diligence) required to make an investment that you are comfortable with. 

    The first part of this article can be found at:
     
    In this article, I hope to educate the reader on the critical due diligence to perform before entering a position in a penny stock,  and provide rationale for critical decision making about when to buy, hold, or sell a penny stock.  For this discussion, we are assuming that you are willing to speculatively invest in penny stock companies for medium/long term gains (buy and hold), and are not trading  penny stocks on momentum or volatility (pop and drop). This is the classic stock market investing strategy. However, in the case of penny stocks, their high levels of volatility can often make this approach gut-wrenching. As well, it is a statistical fact that far more companies trading for pennies will whither away and die than be successful. So when employing this strategy, an investor must be extra cautious not only in their due diligence, but also must be very attentive to company developments and stock movements to protect or improve their profits. 
     
    Most of the time, penny stock companies are ones that you never heard of…..that is one reasons they are in the pennies. I often say to people “stocks are popularity contests”, pointing to the simple fact that volume is what moves stock prices more than anything else. The “greatest company in the world”, if it exists, will not attract investors and see share price appreciation if no one knows about it. Likewise there are many fundamentally flawed, but popular, companies out there who see incredible share price appreciation based solely on popularity (I will refrain from naming some, but I could name 10 off the top of my head, mostly in the REIT and finance sector).   For the penny stock investor your are taking advantage of this simple fact to buy stocks that quite inexpensive because they are simply underappreciated and ignored but yet hold great promise for the near future.
    With this strategy, you are walking in the footsteps of the very famous Fidelity Magellan fund manager Peter Lynch, who was not afraid to invest in micro-cap companies and as a result netted a 29% average return year over year for the 13 years he managed that fund (FMAGX). Lynch’s stock-picking success was because he diligently searched and would find an overlooked stock in an unpopular sector, often in the penny stock range. He learned as much as possible about a company’s business, industry and future prospects. Every investor who wants to employ this strategy should read his book “One Up on Wall Street” as well as his follow up book “Beating the Street”.   Indeed, Peter Lynch is regarded as the person who coined the “10 bagger” phrase, meaning a stock which appreciated to 10X (1000%) of the purchase price. This is exactly the kind of stock we are all looking for when we invest in penny stocks. Peter Lynch found these ignored stocks, performed the necessary due diligence, studied the industry sector they were in until he became an expert, and waited for his holdings to gain the recognition they deserve. Sometimes this took a short amount of time, sometimes years, but by doing so, he made billions for his fund, and many consider him the greatest value investor of all time. 
     
    Lynch talks about different types of companies that can become the proverbial “10 bagger” for this type of investor.   The ones most relevant to penny stocks are what he called:
    1.    “Turnaround plays”
    Companies long in development who have burn through enormous amounts of cash and are long forgotten but are about to finally realize the fruits of all the efforts (typical of biotech stocks)
    2.    “Value plays”
    Companies who have very low price to earnings ratios for their sector (many unknown companies meet this criteria).
    3. “Fast growers”.
    Small companies that show tremendous growth in revenue quarter over quarter, year over year (this is the key thing you should be looking for)
     
    To meet the Lynch criteria for buy-and hold investing (loosely) you should seek out companies that have the following criteria:
    1)      They are profitable or near-profitable:   As many penny stock companies are in the development stage, they wont show profits. But consistent revenue close to profitability may allow them to trim costs and become profitable (a variation on the “turnaround play”. 
    2)      Unpopular: This is characteristic of most OTC stocks. Stocks on the major exchanges may have higher per share prices simply due to the “popularity contest”. A viable, profitable company trading in the pennies fit this profile, or they wouldn’t be pennies.
    3)      Low or no debt: Debt kills small companies. Most penny stock companies are drowning in it. Even if revenues are growing, they ultimately may go to their creditors if they are behind on debt (of course many large companies are facing this right now also!)
    4)      Revenue growth: The potential in a company’s product can be judged by the growth in its sales. Even if it is not profitable, judge how it may become profitable with a continued rate of growth.
    5)      Value priced:  Its market cap should be significantly smaller compared to similar companies. 
     
    Such companies do indeed exist in the penny stock world (read my CEMI blog), but there are few and far between, and if they meet these criteria they don’t stay unknown for very long.   But if you become aware of a company that appears to meet this criteria, don’t jump in head first.  Don’t be fooled by a large announcement of profitability or large sale/contract- dig deeper before buying. For example, a company who sells $10,000 of product one quarter and $100,000 the next quarter could rightfully claim “1000% increase in sales”. Be sure to look behind the numbers- are these sales enough to support the company? That aside, this level of  growth rates aren't sustainable, as next quarter they would have to sell $1,000,000, or 100X the amount of two quarters ago to sustain that level of growth. As well, if their product/service is growing at such a rapid rate, other competitors are sure to jump in on the action and but a cramp on their market share.
     
    Also, study the debt carefully: A company may appear to have little debt but actually have convertible debt that would cause massive dilution of the shares. Worse yet, most of the time events of default (not being able to pay the principle or interest on debt) will trigger the transformation of these notes into common shares. As well, the company may have no debt on the balance sheet, but may have had their debt transformed into convertible preferred shares at some point (discussed in part 1). In both cases, a common shareholder could face massive dilution, dramatically diminishing the value of their stake in the company. 
     
    In order for a company to meet the criteria of being  “value priced”, don’t just pay attention to the share price. Pay close attention to the share count and market capitalization. Surprisingly, this is something that most investors overlook. A company could have shares trading only at at ten cents, but have 1 billion shares issued.  This would give that company a market capitalization of $100 million. Ask yourself: Is this justified for a company who only generates no revenue, has no cash, lots of debt, negative stock holders equity? You are likely to find many, many companies with market caps this size who generate hundreds of millions of dollars in revenue, and are profitable and listed on the large exchanges. Does that seem reasonable for a Pink Sheet stock you never heard of before to have an equivalent market capitalization?
     
    Study the balance and cash flow sheets carefully. You are looking for revenue from sales, not from selling off company assets or debt forgiveness, as these are one-time recordings. If a company suddenly announced profitability due to debt conversion into common shares, this is recorded as income, when it is not income driven by sales at all. As well, look out for high accounts receivable on the assets side- can they really sell all the inventory? If not, it is worthless and will have to be liquidated and will end up on Ebay for pennies on the dollar. Also, if a company has a large amount of cash suddenly compared to the year- where did it come from? If they borrowed it or sold shares to raise it, this may not be ideal for the shareholder, Finally, don’t believe the “goodwill” statement for a company’s assets: “Goodwill” is a self-stated value for the value of the company name, its business model, and reputation. Many times, this will be the majority of a company’s assets.   If a company is one you never heard of, has no client base, and not sales, its “Goodwill” is worth nothing, no matter what they say it is worth. This is especially true for bankrupt companies, who have significant value in Goodwill; that is before they went bankrupt! 
     
    All of these things can turn what appears at first glance to be an exciting company you heard about from a press release or message board into an investors trap. You will be grateful you spent the time performing a little due diligence to look behind the curtain and see what the company really has to offer shareholders. Because of the volatility in penny stocks, and rapid movements on positive news, there is always an urgency to buy, but fight the temptation. The stock price may indeed be rising as you spend the time to do the proper research, but I will show you how to perform 6 minutes of diligence that will help you make quick decisions to buy or avoid a stock (see the process below). If the company is a good company, whether or not you paid one penny or two pennies a share wont matter in the long run. If the company is a lousy company and you didn’t spend the 5 minutes to perform basic due diligence, you will jump in to get a “cheap” price and you will wonder why the share price continues to fall after you bought in. The reasons for this are unfortunately because other people did more diligence than you did, and made a decision to sell rather than buy or hold.  Instead of a “10 bagger”, you are looking at being a “bag holder”. 
     
    However, it is tempting to try and take advantage of the rapid build in momentum of penny stocks. It is easy to look at a chart of any penny stock and see the 10 bagger potential if you had bought in one place and sold in another. But this is not easy: Not only do you require a calm hand and a stomach of steel, you need a good understanding of technicals, level II quoting, and a sizeable trading account with lots of liquidity. In a nutshell, when trading the volatility of penny stocks, your working assumption is that you are just a little smarter/better/faster than all the other people trying to do the same thing. For trading purposes, one of the best phrases I ever heard was “don’t let due diligence ruin a perfectly good trade”. What that means is when trading the volatility of penny stocks, you are only concerned with what is driving the price movement (news, speculation), the current trends, the bid and ask, and so on. You should be aware of the fact, however, that there is a large pool of people trying to do the exact same thing you are , and you may not actually be smarter/better/faster than them. In fact, if you are not a daytrader as a living, you should assume you will have more failure than success at this.
     
    So unless your are a day trader, you should only decide to enter a stock based on your due diligence. There should be a direct relationship between how much due diligence you did and how much you invest. Don’t try and enter a position all at once- buy in small pieces. If the stock is fast on the rise, perform the 5 minute due diligence described below and buy a “starter” position. Perform more due diligence, and if satisfactory, buy more- the $8-$13 you pay per trade pales in comparison to the amount of money you are investing. If the stock is volatile, your due diligence will give you confidence to buy on the “dips” and accumulate more. During this process, should take hours and may take days even, the true up/down trend of the stock will become more clear and will allow you to make better decisions about what a good price point is. During this process, you can decide how much of your portfolio you are willing to invest (based on your continuing due diligence) and decide to average up or down in your cost basis. Sure, your gains may be muted some compared to if you just dove into the stock, but so will your losses if it turns out to be a bad decision. The technical term for this is called “risk weighted investment”, and should ALWAYS be used when investing in penny stocks.
     
    Hopefully this process will help you to decide when to buy a stock with confidence, but how do you decide when to hold or sell a stock ? When you bought a stock and are in the green, you have to consider taking profits. When you are in the red, you have to consider selling at a loss. These are difficult decisions, with the latter being the most difficult.
    There are two old phrases I will put up for consideration:
    1.      “It is easier to decide when to buy than sell”. 
    2.      “ Hogs get fat, pigs get slaughtered”. 
     
    The first phrase refers to when should you take profits, or when should you sell at a loss and walk away. The best way to do this is to sell when you have met your investment goal, and dont hold onto a stock outside of your confort range.  Decide what this will be early on, even before you buy the stock (more on this below). The second phrase refers to that concept that a profit is a profit, even if it is not the most profit you “could have” made. No one can predict exactly how high or low a stock will go- you can only educated guesses, and often those are even wrong.  If you continually make profit, your portfolio will grow, plain and simple. Getting too greedy, trying to call the peaks or the troughs, will far more often mean losses rather than gains. Set a calculated entry and exit point based on your best guess early on in the decision making process. Don’t try to buy a falling stock (“catch a falling knife”) or try to predict the peak of a stock, what until the trend is clear even if it means you pay more to buy it and get less when you sell it. As long as you see profit, you are doing well.  
     
    The best way to decide when to sell with a profit or loss is to come up with an exit strategy BEFORE you invest. First, determine how much you are willing to lose, if necessary. Once you have bought in, either mentally (if you have time to watch the stock closely) or literally set a stop loss- the price at which you will sell and walk away if you are down on your investment. For me, I consider the current activity on a stock- if it is up 30% I need to be prepared to lose 30% if it returns to the previous level. If it is up 100%, I need to be prepared to lose half my investment if the stock returns to its previous level. This is a very simple and fast way to determine risk and weigh that as part of your investment strategy. Set your loss limits and stick to them, don’t look back after selling- far more often than not, selling turns out to be the right choice in hindsight, especially in penny stocks. Far too many penny stock investors are unwilling to sell at a loss and watch helplessly as their investment dwindles and never recovers. 
     
    As well as anticipating losses, set reasonable goals for realizing gains on a stock ahead of time and stick to the plan. Ask yourself: Do I expect a 30%, 50%, 100%, or even 1000% gain, and in how much time. It is normal for penny stocks to move 30-50% in a day on the right news. In general, the faster a stock rises, the more unstable that price is. It is better to see 10% gains per day for 10 days straight rather than 100% in one day as this way a stable base of investors set up new support for the stock.. Don’t be afraid to sell for a profit at this level. I have seen many stocks I sold for a 50% return keep on climbing, giving me what could have been a 200% return. My response to this is: “oh well, I made 50%”- a highly respectable return. I have also seen stocks I did not sell for a 50% return give up all their gains just as fast, and move into losses quickly, so be happy with any amount of profit. At the same time, be adaptable; change your plan if you come across new information. You may later realize that a stock is diluting, or the management was involved in previous stock scams. Make the decision to sell with minor profit or loss, as now the company is not the same type of company you thought you were investing in. On the flip side, sometimes you own a stock that releases exciting news and there is little or no response.. It may be that investors just didn’t hear the news and subsequent press releases or announcements by stock profilers get investor attention later and the price soars (remember- stocks are popularity contests). If the company has sound fundamentals, ride out the dips and peaks and hold for the long term. Peter Lynch proved this approach works.
     
    When making the decision to buy or sell, it is important to recognize why a stock is moving up or down. In general, high volume buying frenzies are good, and high volume sell-offs are bad. If the stock rises fast on low volume, it is unstable; and likewise if it falls on low volume, it will recover if the fundamentals are there. If the stock goes absolutely nowhere on abnormally high volume, suspect dilution. If the stock sells off on every news release, suspect that the stock is a scam. If volume is 3-4X or more than the average and the price moves in either direction, take that as a sign of a trend being formed- there is strength in volume. 
     
    Also, it is important to recognize when traders are moving a stock compared to when investors are moving a stock. Investors will trickle in slowly, causing a steady increase over days and weeks; traders make a stock move in hours. It helps to have a good understanding of TA for this, but some simple signs of traders entering and exiting a stock are determined in the first and last 30 minutes of the trading day. On an uptrend, traders will move the stock the first hour after open, and sell off their positions the last hour of trading. On a downtrend, the exact opposite is true- traders sell off early and buy back in the lows immediately following. Use these clues wisely to decide whether the stock is being moved by traders or investors, and form your entrance and exit strategy accordingly. If traders are moving a stock, it will be volatile and you will likely have the opportunity to buy in later in the day on a dip. Likewise, don’t be afraid to sell on a massive momentum pop, you can buy back later if you are in for the long haul. If investors are moving a stock, it is generally slower so there is no need to rush, and there is no need to panic if the stock begins to trend down.
     
    If you set reasonable goals based on your understanding of the company, you will be rewarded with patience. If a company is fundamentally strong, the stock may up and down on a daily basis but if your strategy is buy and hold, you can make lots of money over time, ending up with a nice healthy 10 bagger to boost your portfolio. You can do this time and time again, and see hundreds of percent in return on your portfolio by establishing a sound research routine and determining a trading plan ahead of time. As Peter Lynch proved for 13 years straight, this is a time tested method for making money off microcap stocks, and with practice and patience, you can be just as successful.
     
    MULTI-BAGGER OR BAG HOLDER?
    6 MINUTES OF DUE DILIGENCE WILL DECIDE
     
    Here are the 6 minutes of absolute minimum due diligence I perform before trading a stock. I prefer to do much more, but when a stock is moving on news and momentum there is often urgency to make a decision. This quick process is for these situations when time is of the essence and will help you to decide how much confidence you will have in your potential investment; and thus allow you to weigh the risk. For long term investment, it is much healthier to spend the time doing more research, but in the penny stock world of massive volatility, I often use this method to make quick decisions to enter into a starting position as described above, with the intention of adding more later or selling off my existing position as my due diligence indicates.
     
    STEP 1: 30 seconds.
     Go to www.pinksheets.com and enter the company ticker. First determine its reporting status. Only invest in companies you can collect information about. More information regarding this can be found on:
     
    There are several different levels of reporting status that directly speak to a company’s ability to run a healthy business. In general, the worse the reporting status, the less likely it is that company will be able to reward shareholders. 
    a. “OTCBB or Pink Quote” means that they are SEC reporting and current in their reporting obligations You will be able to view everything about the company via SEC filings.
    b. “Pink Sheets Current Information” means that they submit filings to regulators with powers of review and make the filings publicly available on the Pink Sheets. This is not to be confused with SEC reporting. This does however, allow you to review information supplied by the company. This category includes shell or development stage companies with little or no operations as well as companies without audited financials and as such should be considered extremely speculative by investors.
     c. “Pink Sheets Limited Information” Reflects companies with financial reporting problems, economic distress, or in bankruptcy to make the limited information they have publicly available. This category also includes companies that may not be troubled, but have not submitted information to Pink Sheets, but have filed SEC documents within the last 6 months. 
    d. “Pink Sheets No Information” Indicates companies that are not able or willing to provide disclosure to the public markets. This category includes defunct companies that have ceased operations as well as 'dark' companies with questionable management and market disclosure practices.
    e. “Grey Market” means that no market makers are in this security. It is not listed, traded or quoted on any stock exchange, the OTCBB or the Pink Sheets. This is not a reflection on the company itself, but these stocks are generally illiquid and difficult to trade.
    f. “Caveat Emptor” literally means buyer beware. This means Pink Sheets has determined that there is a public interest concern associated with the company, which may include a spam campaign, questionable stock promotion, known investigation of fraudulent activity committed by the company or insiders, regulatory suspensions, or disruptive corporate actions.
     
    Use this to triage your decision. Ask yourself: Are you willing to invest in a company you cannot find any information about? If a stranger came to your door and asked you for $1000, promising to give you a healthy return on your investment, but not telling you how, would you give it to them? Publicly traded companies that are not willing to provide information to investors should be treated with suspicion and their securities should be considered highly risky.
     
     
    STEP 2: 1 minute
     
    Click on the “company info” tab. 
    Here will be a brief business description, link to a company website, state of incorporation, etc.   Don’t visit the company’s website just yet; save that as a second layer of due diligence later.
    a. Look at the company notes (upper right). Has the company changed names and apparently types of business several times? This is a red flag. Ask yourself: Do I trust a company who cannot specialize in a single area of business (would you trust an auto repair shop that used to sell tacos?)
    b. Look at the number of employees the company has (middle left). Is the number of employees sufficient for the business?
    c. Look at the primary company officers. A very simple thing to do to avoid shady management is to go to Google and type their name along with the word “scam”. You would be surprised how much you can learn in 30 seconds by doing this.
    d. Look to see  if they capital changes and security notes (upper right). Multiple reverse splits (“shares decreased by…”) are indicative of long term dilution (increasing the number of shares though dilution and then reverse split to hide the dilution).
    e.  Look at the number of authorized and issued shares (make sure it is up to date). Small companies with billions of outstanding shares suggests that they are managed poorly and can only raise money for the business by constantly issuing shares.
    f. Finally, look at the market capitalization listed on the bottom right. Is it reasonable based on all the other information you found?
     
    This information is not always current or precise, so don’t base all of your diligence on it, it is just to be used to make a preliminary decision to avoid the stock all together or look into it further. If things don’t seem to add up, don’t buy in.
     
    STEP 3: 2 minutes
     
    Type in the company name along with the word “scam” on Google. You will likely be directed to message board messages (Google, Yahoo, Investorshub) from posters using this phrase. It is a common phrase to use, and often it is just disgruntled posters complaining, but see what they have to say- many times they are the ones who have done significant due diligence and found major flaws in the company. If you read 4-5 messages that appear to have substantial validity to the claims, you should not dive in to the stock and perform more lengthy due diligence before buying.
     
    Step 4: 2 minutes
     
    Using the tools in your brokers website, perform some simple technical analysis. You don’t have to be an expert- just a preliminary glance at the stocks behavior.
     
    a. Look at a 3 month chart- has the stock been rising the last 1 month or falling? If it has been rising, that suggests that investors are buying in, if it is falling (despite what it is doing the last day or two) then investors are leaving the company. The moving average (MACD) should be positive on a rising stock and negative on a falling stock.
    b. Look at the volume on the 3 month chart. A healthy stock should show increasing volume with a rising price. A rapid increase on low volume is likely to be followed by a drop in the price. A drop on high volume is a red flag. Also decide if the volume is sufficient- it should be at least 100X the number of shares you want to buy, or you will have trouble buying/selling the stock.
    c. Look at the accumulation/distribution (A/D) line on the three month chart. This line should follow the price- accumulation should go up when the share price rises and should go down or remain steady when the price is going down. If there is a disconnect between the A/D and the price that is a red flag. If the price is rising and so is accumulation, that is healthy. If the price is rising and accumulation is not, that is suspect. If the price is dropping and so is the accumulation, that means investors are leaving the stock. Massive volume with negative accumulation shows that dilution is taking place.   A company which is constantly diluting will show a long, steady decline in the A/D line. A scam company which sells shares on news will show a sharp dip in the A/D line with every news release.
    d.  Look at the Bollinger bands. If the stock is outside of the top band, it means it is likely overpriced and will adjust down.  If it is below the bottom band it is selling off- don’t try to catch a falling knife; let the stock settle if you want to buy a falling stock.
    e. Look at the 20 day exponential moving average (EMA). If the stock price is in line with the 20 day EMA, you will be getting it for the right price.
     
    This quick technical analysis, although far from complete, will help you determine if you are getting in the stock at the right price. These concepts may seem foreign to you, but with a little practice they will become second nature. You may have to go slightly outside of the “safety zones” discussed above when a stock price is changing rapidly, but if this is the case you should reduce you risk by buying less shares.
     
    Step 5: 30 seconds
    Fill out the order information. Before you execute the order, pause for 30 seconds. Think it through objectively. If the news about the company seems too good to be true, it probably is! If the stock is running up on no news, stay away! Set aside your greed, as it always clouds your judgement. Pretend that you have the money you are ready to invest in your own hand as cash: If a stranger came to your door selling you the product (shares in the company) you just researched, would you willingly hand them that money? Trust your gut feeling.  
     
    These 6 minutes are usually sufficient to pick out the obvious losers. If a company still looks promising, spend another 20 minutes looking into it more. Follow through by visiting the company’s website, viewing SEC documents, reading message board posts. If you can’t find a reliable source for the share count, call the transfer agent listed on Pinksheets. The longer it takes to find the “red flags”, the more sound the investment probably is. 
     
     
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  • Great Article.....I feel like I have a much better grasp now than before on the logic behind all this...
    2 Jun 2013, 03:32 AM Reply Like
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