Which penny stocks are worth a thought?

Image: finweek archive
Image: finweek archive

There are numerous penny stocks – small-cap companies with a share price under R1 – on the JSE’s main board and they may seem attractive to retail investors, especially first-timers who want to enter the world of investment.

A few former mid-cap names – in particular construction companies such as Aveng, Basil Read and Group Five – have fallen to the penny-stock category as South Africa’s economy tanks under poor government policy decisions, and a dearth of fixed capital investment by companies.

Nevertheless, there are several penny stocks that shimmer and may prompt a closer look, but investors shouldn’t necessarily be adding them to their portfolios. 

finweek has identified four stocks that are geared towards a changed future economy, or pose value in terms of their share price.The returns story on the FTSE/JSE Small Cap Index is a mixed one at best. 

The index – which includes those stocks not selected for the FTSE/JSE Top 40 Index or the FTSE/JSE Mid Cap Index – declined 4.1% last year, slumped 14.6% in 2018, rose 3% in 2017 and jumped 20.9% in 2016 (see the table below for comparison).

Considerations with penny stocks

The decision to invest in penny stocks should be premised on a solid analysis of a company.“With penny stocks, much of the value lies in their prospective growth in income and as a result, historical valuations are of lesser significance,” says Ricus Reeders, portfolio manager at PSG Securities. 

He recommends two factors to look at when considering penny stocks due to margins in these companies typically being slim.Firstly, the potential investor should look at a company’s earnings momentum. 

“Are the company’s earnings not only growing but is the rate of growth also increasing?” he asks. The momentum in earnings could either be the result of revenue or margin increases or the effective management of cash flow, according to Reeders.

Secondly, the investor should determine whether growth in the company’s assets, expenses and debt is covered by cash flow, says Reeders. “Are these two items sustainable and cogent?” he asks

Cover Story Table

Benefits and pitfalls

After deciding on a penny stock to invest in, the investor should weigh the benefits and pitfalls of investing in these instruments. 

There are two benefits that stand out.“If the investor is fortunate enough to have invested in a company that grows revenue, market share and acceptance from a growing client base, returns can be well above normal,” says Reeders.

As the focus is on future potential rather than current valuation, shorter-term economic conditions might have less of an effect on the company’s business and as a result provide a measure of “non-symmetric risk”, according to him.

On the other hand, pitfalls – as is the case with any small-cap stock – should be carefully considered.

Market liquidity, in the first instance, may affect the ease of buying or, more importantly, selling a stock.“If the stock is tightly held, the investor might not be able to buy in sufficient numbers at the right price or sell easily,” says Reeders.

The pricing mechanism may not be working properly with penny stocks. “As penny stocks in general, because of their size and market value, do not attract institutional investment, the price might remain undervalued and neglected for a very long time,” he says. 

“Patience might be a virtue but an acceptable rate of return over time is what counts.”Finally, Reeders says that the headline-grabbing narrative of “rags to riches” is the exception in the market rather than the norm.

“Most small companies either fail or get bought by competitors – hopefully at a decent price. Be aware of and prepared for that risk.”

This is a shortened version of the cover story that originally appeared in the 6 February edition of finweek. To get the full story, including the stock picks, you can buy and download the magazine here or subscribe to our newsletter here.

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