Penny Stock Industry Report:
How to Research a Penny Stock By Ed Zwirn
P
icking the right penny stock of course involves an element of luck. The company in which you invest can see its CEO, the prime mover and founder of the enterprise itself, drop dead of a heart attack or (possibly worse) get involved in messy, expensive divorce proceedings. The market can turn against you and your penny stock. The industry or sector in which the company does business can suffer a dramatic, unpredictable reversal. Of course, larger, more established companies have a better chance of recouping from unforeseen developments. Unlike their cheaper cousins, they usually have much greater capital reserves and a larger pool of investors on which to draw. This resilience, of course, means that blue chips, while a safer investment, can offer much less opportunities for tremendous gain. Penny stocks are at the opposite end of this risk/reward spectrum. Not only does the market assign them a lower value, it does so for a very good reason: Penny stocks usually come on the scene as “one-trick ponies,“ with investors in them gambling (and sometimes winning big) that the trick performed by these ponies will prove indispensable. If this happens, as it sometimes does, those buying penny stocks can reap huge rewards to compensate them for their huge risk. But there is more than luck involved. By doing the right homework, or “due diligence,“ investors can improve their chances of success and minimize the impact of unpredictable events. And this homework is not as daunting as it may appear.
Ask yourself whether you would pay extra for an auto which has, say, an enhanced emission system or gets lower fuel mileage. Ask your friends and relatives the same question. In addition, you need to consider what proportion of the “universe“ that this company would be able to capture, and whether it will be able to do so better than more established competitors. If the basic scheme of your penny stock company makes sense to you, you should proceed to the next step, which is a look at company financials. These financial reports, which are required to be released quarterly by all companies trading on exchanges, tell two basic stories: THE INCOME STATEMENT: The income statement presents the results of the company’s operations (that is, the money it made from the sales of goods and/or services) over a given accounting period. Even if the company you are considering has yet to turn a profit, you should be able to get an idea of the money, if any, it is taking in (revenue). Beyond that, an income statement gives you a picture of how much it costs to take in this money. You can’t manufacture a product without spending money on equipment, salaries and (as is usually the case with penny stocks) research and development. On the other hand, you might find that much more money is being spent on salaries and other perks for company executives. There may be a reasonable explanation for this, such as the need to provide an incentive to lure an executive from an established firm, but larger pay and other incentives for the top brass could also serve as a red flag.
Sample Fictional Company – Income Statement
COMPANY FUNDAMENTALS For starters, you need to get a handle on the basic business logic underlying your penny stock. In other words, how does this company intend to make money, if it isn’t doing so already? In most cases, this type of information is readily available by looking at things like company websites, the press releases put out by the company and the comments issued by industry analysts and other specialists in the field. For example, if the company you are considering, XYZ Inc., proposes to make a killing manufacturing and selling a new accessory for automobiles, you need to consider what the total market for such an accessory might be. In marketing parlance, this is called the “universe.”
Fiscal Year Ended April 30, 2009 (all amounts in thousands) Operating Revenue (Income) Cost of Goods Sold (COGS) Gross Profit Margin
100,000 40,000 60,000
= this is their total sales = cost to create the product = revenue less cost of goods
Research + Development Selling, General, and Administrative Advertising Operating Expenses
5,000 10,000 15,000 30,000
= = = =
money spent on R+D costs of SG+A advertising costs total of above three items
Total Expenses Net Profit (EBITDA) Depreciation Earnings before Interest + Taxes (EBIT) Interest Taxes Net Profit (after Taxes)
70,000 30,000 1,000 29,000 500 500 28,000
= = = = = = =
COGS + operating expenses revenue less total expenses depreciation expense net profit less depreciation interest payments on debt income taxes paid how much they really made
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www.PeterLeeds.com BALANCE SHEETS: The balance sheet provides a snapshot of company assets at a given point in time. Since penny stocks have in effect to make money before they run out of cash or money they can tap readily to pay bills, looking at balance sheets for these smaller companies is probably more important for penny stocks than it can be for larger companies with deeper pockets. Reviewing your penny stock company’s financials should give you an indication of not only whether it can ever be profitable, but whether or not it has enough in the way of cash to burn through until it reaches profitability. If you are still unsure after doing this portion of your homework, you can contact the company’s Investor Relations department directly. Be sure, when and if you make that call, to have specific, targeted questions for the person answering the phone (or the email). The tone and specificity of the answers you get should give you an idea of whether this company means business.
www.PeterLeeds.com Offerings of stocks under $5 dollars that hit Canadian exchanges from 1986 to 2003 found that energy and high-tech companies were several times more likely to hit it big, which is not surprising if you consider both the run-up in oil prices and the tech explosion which occurred over that period. Most of us don’t possess crystal balls, but an informed outlook on trends like these can only help you decide which stocks to buy.
ANALYSTS and NEWSLETTERS
MARKET ANALYSIS No company operates in a vacuum. There were certainly many excellent companies out there at the time of the 1929 stock market crash, but most of them went under due to prevailing market and economic conditions. The risk posed to all companies, or all companies operating within a particular industry or sector of the economy, is usually referred to by economists as “systemic risk.” All bubbles, assuming they are bubbles, burst eventually, usually to the detriment of the poor suckers who were the last to hold on to the asset. This is true for both the market in general and for the specific industry in which a company is competing. In terms of the general stock market, you should be aware that the Dow Jones Industrial Average, the S&P 500 and other market indices out there are good indications of not only the prevailing sentiment of investors, but is also a pretty good indication of how wealthy these investors in general are (or at least think they are). All markets are subject to periods of what Alan Greenspan, former chairman of the U.S. Federal Reserve Bank, called “irrational exuberance.” During periods like these, your relatives and neighbors start talking about the stock market. This is of course a great money-making opportunity while it lasts, but the smart investors will know when to bail. On the other hand, down periods could offer buying opportunities, especially in companies that are otherwise strongly positioned but undervalued. The success or failure of a penny stock will also depend on the industry or sector in which it does business. A study of Initial Pubic
But penny stock investors have many newsletters and other free and paid services pitched at them by people with more time to spend on research and (hopefully) better expertise. While free sources of information should never be spurned, they must also be taken with a grain of salt. Is your penny stock newsletter trying to sell you information or trying to sell you particular penny stocks? Penny stocks can be “pumped up“ and then dumped in short order by the unscrupulous. By all means, read what they have to say, but rely on your own savvy. Leeds Analysis and other subscription-based services cost a penny stock investor more up front, but at least they put your investment interests first. In any case, they have track records to judge. That being said, there is no substitute for your own wisdom, and doing your own due diligence.
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Penny stocks by definition often fly under the radar, so while you should of course gobble up any media report and any analyst update you can get your hands on, these information sources will often be more scarce for the penny stock companies you follow. Of course, if everybody knew everything there was to know about your penny stock already, there would probably be less chance to make (or lose) money on it.
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