Traders' views - Stock trading

Penny shares are the smallest of the minnows mooching around the very depths of the stock market. While these micro-cap companies are overlooked by many investors, they will always attract interest for a number of reasons.

Blue chip behemoths have to begin life as a small concern, admittedly not all on the stock market though. But investing in penny shares means there’s a chance that your today's small cap will grow up big and strong and take you along for the ride.

Elephants don’t gallop

And even if they don’t grow from £5 million to £5 billion, smaller shares can still enjoy remarkable leaps when the larger stock market cottons onto some exciting news.

As they are cheap and have a smaller free float, the wider acclaim does wonders for their share price. An encouraging development or outstanding results might send a stock up 15%, 30% or 50%, compared to the large caps where a 1% or 2% move is a significant day’s work. ‘Elephants don’t gallop’ is the poetic analogy employed by small cap investment guru Jim Slater.

A sustained run of penny share outperformance sometimes creates the elusive ten-baggers or other sorts of multi-baggers you sometimes hear about from their proud investor parents.

For example, the greatest gains in any decade will come from smallcaps. Imagination Technologies (DIA) was one, growing from under 20p to over 650p in the last ten years, a rise of over 3,000%. And online fashion retailer ASOS (ASC) was a great one tipped by my old employer GrowthCompany.co.uk at 7p in 2004 and last year topping out at £20; a gain so large that it pains me to even calculate it.

A source of value

Small companies are less well known and less researched. As this example points out, almost 30 analysts cover Apple, while only four cover its small UK competitor Psion. Professional analysts working for stockbrokers, investment banks and asset managers overwhelmingly concentrate on larger companies.

So because they receive less focus, as well as because they are inherently more risky due to the company’s size, small caps can be significantly undervalued.

With excitement must come risk

Trading in micro-cap and small-cap shares can be tremendously exciting compared to backing lumbering brontosaurus blue chips. But as this implies, the potential buzz of watching your little hero shooting upwards should be tempered with the much greater risks of you losing your shirt, shoes and, yes, maybe even your socks.

As fewer people are trading small and micro caps, sometimes it can be even more boring than investing in large caps, with sometimes no movements for days or weeks. And this sparseness of deals can mean bad news or lack of news can send the shares crashing by those same double-digit percentages.

There are many potential penny pitfalls, so never invest too big a proportion of your whole portfolio in small caps (unless it’s on BullBearings, where the risks are only to your pride). Small caps and micro caps should really only represent the added spice in your portfolio.

From across the Atlantic, here’s the Daily Reckoning on the seven deadly sins of small cap investing, where the rules are just as true in sterling as they are in dollars.

How to find penny shares with potential

A potential multi-bagger can come in many forms. It may be a young company with a new idea, like ASOS above, which is going to disrupt the existing market.

Here’s MoneyWeek’s Penny Sleuth on why he likes to find disruptive companies that can create the ‘new industries of tomorrow’, including internet security. As he says: “So long as we choose to live our lives in different ways, there will be growth sectors. I am not saying that these are a guarantee of stock market success. Growth opportunities attract new competitors like moths to a flame, and plenty of money can be spent and much time can pass before these companies are profitable.”

One of the best ways to discover potential fast-growth stocks is to do some research of fast growing sectors. Even when the markets are in turmoil as they are now, there are always a few industries that are still growing, and a few that are managing to tread water.

Oil & gas and minerals explorers are classic microcap territory. A man with some land, beneath which he says he hopes to find oil/gold/copper/coal/etc is an archetypal story from the realms of the Alternative Investment Market (commonly known as AIM and the location of all the UK’s listed micro-caps) where you can find an eclectic assortment of businesses including early-stage, venture-capital backed companies as well as more established businesses which have listed to gain access to growth capital. There are also many potentially exciting technology and IT, biotech and healthcare companies paddling at the shallow end of the market.  

On BullBearings there are many small companies to be found, such as all these companies with prices below 20p here.

Make sure you do some research

With less research and objective opinion on them, it can be difficult for private investors to sort the wheat from the chaff. Research is important if you’re going to be investing your own money rather than using the BullBearings virtual trading platforms.

So do plenty of your own research and reading – although, as the US regulator, the SEC, stresses, “information is the investor's best tool when it comes to investing wisely… but accurate information about "microcap stocks" may be difficult to find”. Some universally useful advice from that source is to:

• Make sure you understand the company's business and its products or services.
• Read carefully the most recent reports the company has filed with its regulators and pay attention to the company's financial statements, particularly if they are not audited or not certified by an accountant. If the company does not file reports with the SEC, be sure to ask your broker for what's called the "Rule 15c2-11 file" on the company. That file will contain important information about the company.
• Check out the people running the company with your state securities regulator, and find out if they've ever made money for investors before. Also ask whether the people running the company have had run-ins with the regulators or other investors.

Finally, let us direct you to some of the many useful sources of small company ideas, including:

• Growth Company Investor www.growthcompany.co.uk
• Investors Chronicle www.investorschronicle.co.uk
• Shares magazine www.sharesmagazine.co.uk
• The AIM Micro website www.aimmicro.com
• Smaller oil & gas and mining stocks feature heavily on Proactive Investors www.proactiveinvestors.co.uk
• MoneyWeek’s Penny Share Sleuth www.moneyweek.com