5 things I look for in penny shares

The appeal of penny shares is partly about price. Shares trading for less than a pound can seem cheap. But price is different than value. Whether it’s a penny share or a higher priced stock, certain consistent principles inform the approach I take to choosing shares for my portfolio.

Below are five things that make me more likely to invest in specific penny shares.

1. A clean closet

One of the tempting things about penny shares can be potential returns that seem high when compared to historical performance. A stock market darling can crash into penny share territory because of a wrong turn, such as an accounting scandal or large profit warning.

These turnaround situations can be tempting but I think it’s hard to assess them accurately as an outside investor. How can I know if all the accounting issues are in the past? Will commercial performance return to past levels, or have customer relationships been irreparably damaged? Questions like these are critical to the company’s future prospects, but it can be hard for me as a private investor to know the answer.

That’s why I focus on penny shares without some recent skeleton in their closet which caused a share price collapse. For example, Hammerson is a well-known property developer. But it’s among penny shares I won’t touch for my portfolio, after its liquidity crunch and rights issue last year. That doesn’t mean it can’t still do well in the future. It’s just that a dilutive rights issue is the sort of red flag that makes me question how robust a company’s business model was historically. In such a case, I wonder whether the same or similar risks could come back to dog the share price again in future.

2. Tangible business results

Penny shares in fields like oil development or diamond mining can be tremendously lucrative. But in many cases, they’re not. Why is that?

Consider a large exploration company like BP or Shell. At any one time they are typically developing many projects at once. Some will be successful, others will be duds. The companies can tolerate the failures because they have large, diversified portfolios of projects.

By contrast, a small company focussed on a single development opportunity can run out of money if that opportunity comes to nothing in the end. That’s because development is often an all-or-nothing activity for them. The company raises capital and spends it over years developing a project. Only some years later does it become clear whether the project is really commercially viable. Meanwhile, shareholders have often heard lots of positive noises about such projects, but without commercial production starting the projects usually won’t have made any revenue.

I prefer companies with a more phased ramp up model, which produce tangible results each year rather than making one wait years for even a penny of revenue to appear. For that reason, I often won’t consider penny shares focussed on a single development opportunity in natural resources that hasn’t yet entered commercial production.

3. Competitive advantage and penny shares

When it comes to bigger shares, many investors focus on the strength of a company’s competitive advantage. But I notice that for penny shares, some investors are more willing to invest in what they think is a promising emerging business area. They pay less attention to why a specific company is well placed to succeed in that area.

With penny shares as with more expensive stocks, one is investing not in a broad idea about market trends, but in a specific company. If a company is involved in an attractive business area but has no competitive advantage, over the long term it may lack pricing power.

4. Process not just people

Now, as in the time of Dickens, companies that trade as penny shares sometimes have impressive sounding people on their boards. As in Dickens’ time, many investors may think, “it must be a reputable business, it’s got Lord so and so on the board”, even if they have only the faintest idea of who that peer is.

That doesn’t mean any board with a City grandee or peer of the realm is a red flag for me as an investor. Such eminent people may have been ennobled precisely because they have valuable knowledge and expertise. But I would apply a test, which is to ask whether I would invest in the business without its current board. If not, then that suggests to me that the company’s business model and process is insufficiently compelling. No matter who’s on the board, I’d be looking for evidence of a business model that could sustain profits for a long period of time.

5. Growth drivers

One of the things I notice about some penny shares is that directors seem to pay more attention to public relations than they do to running the business. Such companies constantly seem to have some promising new business idea, exciting strategic development, or massive new sales opportunity. This isn’t just true of small penny shares. I think British Gas owner Centrica also has a great sounding business in principle, yet often its business results somehow disappoint.

But as an investor, how can I try to assess which claims like this could turn out to be accurate? One thing I do is assess a company’s growth drivers. For example, how big is its addressable market and is it likely to contract or grow in coming years? What technology, expertise, or other asset does a company have which could attract customers to it rather than to competitors? What evidence does the company show of being able to commercialise its ideas? In the case of Centrica, the market for domestic gas looks set to contract in coming years due to political pressure. That threatens both revenues and profits at the company.

Sometimes this involves looking at a company’s track record. For example, one reason I like healthcare landlord Assura is because it has already proven its business model over more than a decade. But conditions can change. So for example, Assura’s revenues could fall if there was a shift of GPs from health centres to mixed working. So I also always look at likely growth drivers for a company.

Specifically, I try to assess how a market will develop. I then ask whether the company in question has the capability to benefit from that in the way it claims.

I think penny shares are a valuable part of my portfolio. But I want to make sure I am investing because I see potential value, not just a low price.

Christopher Ruane owns shares in Centrica. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.