Penny stocks offer huge returns if you can stomach the risks
I get a lot of requests on which penny stocks to buy but don't always have the time to do the research. These can be great investments if you have the time to analyze them and can tolerate the risks.
I took the time over the weekend to dig into an old stock screen for penny stocks and found three that could be a solid fit to a high-return portfolio.
One is already up 43% but could double and another is trading for less than it’s break-up-value.
In this video, I’ll show you how I find penny stocks and reveal the three best stocks to buy right now.
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Should You Invest in Penny Stocks?
We haven’t talked much about how to invest in penny stocks on the channel but it’s an investment with huge upside if you’re ready to take the risk. In fact, a stock I recommended in July last year is already up over 174% in the last eight months.
In this video, I’m going to take you through exactly what I look for to find the best penny stocks from the stock screen to the deep research. I’ll then reveal three penny stocks I’ve been watching that could be your best investments of the year.
I do want to warn you though, like I said, penny stocks and micro-cap stocks are extremely risky. You can lose everything just as easy as see that two- or three-times return on your investment. Because of that, I wouldn’t recommend having more than maybe 10% of your portfolio in these stocks. This is why I’m starting the video off with the process I use to find penny stocks. It’s not enough to just drop a few stock picks. I want you to be ready with the knowledge of how to find these opportunities and be able to avoid the risks.
Why Penny Stocks Beat the Market
Penny stocks can offer some great opportunities though because they’re not widely covered by analysts like the Amazons or the Apples in the market. There are 41 analysts covering Amazon. That’s 41 Wall Street analysts spending their nights and weekends digging into the financials, calling contacts and suppliers. There just isn’t that much new to be discovered.
In fact, the average earnings surprise for stocks in that large-cap S&P 500 is just 3.5%. That means analysts are off by less than four percent predicting the profits of these companies. Compare that to an average surprise of 11% on penny stocks and it’s clear there is just more opportunity in these smaller companies.
A Basic Stock Screen for Penny Stocks
Looking for penny stocks, I’ll usually start with a basic screen to narrow the list. Now I’m using Morningstar but just about any online investing platform will have a screener you can customize. I’ll start by filtering for stocks with under $750 million in market cap. This might not seem like a penny stock company but it’s extremely small when you consider the average market cap in the S&P 500 is $229 billion.
Then I’ll filter by revenue growth and operating income. First, I like to see that the company is growing sales but more importantly I want to see that it’s growing its operating income faster. So maybe I’ll put in revenue growth greater than or equal to 5% and then greater than or equal to 10% when I filter for operating income growth. Since operating income is the sales minus cost of goods and minus all those operating expenses, if the operating income is growing faster than sales growth, it means the company is also cutting some of those costs. That means it’s getting more profitable, more efficient, even as it’s growing sales and that’s a great sign for these smaller companies.
One last thing I’ll screen for is cash flow from operations. Most investors get hung up on earnings, it’s what everyone talks about and everything you see is about earnings. What’s more important though, and this is what professional analysts look at, is cash flow from operations. You see, there are all kinds of ways a company’s management can manipulate earnings or profits. They can delay some expenses or book some sales early, anything to make the earnings look higher than expected. It’s all accounting gimmicks on the income statement.
Now the statement of cash flows, that’s actual cash coming in and out of the company, and it’s much harder to stick lipstick on this pig. If a company isn’t doing well but is using all kinds of accounting shenanigans to make itself look profitable, you’ll find it in the statement of cash flows.
So I’m back in the screener, I scroll down to cash flows and I’ll just filter for companies with cash flow from operations in the most recent year that are higher than the previous year. This tells me the company is growing actual cash from the business year over year. I can also carry this back further like filtering for higher cash flow in year two over year three but we’ll just keep the one filter for this example.
Now that simple stock screen still left us with over 140 potential penny stocks so I would probably play around with the filters until I got it down to 30 or 50 stocks. Then I would go on to my fundamental and catalyst analysis.
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Fundamental Analysis for Penny Stocks
We won’t get too far into that fundamental analysis or the catalysts I look for because I want to get to those three penny stocks I found while researching for the video. If you want me to make a video detailing my fundamental analysis or other ways to pick stocks, click through to the video and let me know in the comments.
Basically, fundamental analysis is looking deeper into those cash flows and other financial statements. It’s looking at the industry in which the company operates and what advantages it has over competitors.
For example, in fundamental analysis, I’ll first look to make sure cash flow from operations and net income are growing at around the same rate each year. This is an old school analyst trick to seeing if company management is trying to play shenanigans with the income statement. Net income growing at a slightly faster rate than cash flow, as in the case of Apple here, might not be an alarm but it does signal some accounting tricks by management to make the profits look better than they might actually be. If net income or earnings are growing much faster than actual cash flow, it’s a warning sign that something is fishy in the accounting.
Beyond looking at the financial statements, I’ll also look at some of the valuation measures like price-to-earnings or price-to-sales. One important warning here and we’ve talked about this before on the channel is that when you’re comparing stocks, you absolutely have to compare stocks within the same industry. It does no good to compare a price-to-earnings ratio of a tech stock against the ratio on a bank or a telecom stock. Industries have different characteristics like growth and debt so you have to be comparing apples-to-apples. You want to find the best of breed within each industry, don’t try to find the very best stock across every industry.
Finally here before getting to those three penny stocks is I’ll just look for a general catalyst, an event that could move the shares big time. Whether this is the potential for a takeover or a big project to be announced or just a change in the overall supply/demand picture. You’ll find solid companies and stocks with what we’ve covered to this point and they’ll be good long-term investments. Finding that near-term catalyst though just means you’ve got a better chance at seeing a quick return rather than waiting.
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Best Penny Stocks to Buy in 2019
Using this filter and analysis, I’ve narrowed the list to three of the best penny stocks to buy now. Strong companies trading for under $1 per share or under $750 million market cap that could be about to take off.
Our first penny stock is Eldorado Gold, ticker EGO, a $690 million gold miner with 11 major projects around the world. Eldorado has assets in Canada and Brazil but the majority of mining is being done in Eastern Europe, Turkey and Greece.
Management recently reported its 2018 performance, producing 350,000 ounces at an operating cost of $650 per ounce and an all-in-sustaining cost of $994 last year. They guided up to 420,000 ounces this year and up to 550,000 next year. Not only is production expected to boom as much as 57% over the two years but costs are expected to come down at least 10% to an all-in sustaining cost of $800 to $900 an ounce this year.
So you’ve got a good medium-term picture on the shares and they’re up 43% so far this year but the stock still trades for a price of about a fifth it’s book value. That’s about an eight of the 1.73 average price-to-book value for other miners.
The big overhang for Eldorado is its Skouries project in Greece which has been constantly delayed on permitting by the government. The company has won a couple of arbitration agreements and the government is supposed to be getting out of the way so if the company can get that worked out, it could mean a big jump in the shares.
Our next penny stock is Precision Drilling (PDS), a $724 million leader in North America oil and gas production. The company reported an excellent fourth quarter with revenue 12% higher as well as profitability gains. Drilling in the U.S. increased 15% with the company reporting a 5% increase in rigs versus an average increase of just 2% for competitors. Besides the 240 drilling rigs and 210 service rigs it has in North America, it also has 17 drilling rigs internationally in Saudi Arabia and Kuwait.
Precision is in just about every major field development in North America and controls more than a fifth the land drilling market in Canada. The United States passed the Saudis and Russia last year to become the world’s largest oil producer. Sanctions on Iranian and Venezuelan oil will keep prices higher and could even drive crude further this year.
Debt has been an overhang on the shares with almost $1.3 billion in long-term debt on the balance sheet. The company has been aggressively paying this down, retiring more than $330 million in the last few years, and has no maturities until 2021. That means a lot of financial flexibility and an improving debt picture for the next two years and it could mean catalysts for the shares.
Our third penny stock is the smallest of the group and frankly, when I was a full-time analyst, I wouldn’t even have considered it. The big fund managers I worked with needed to place hundreds of millions in investments and didn’t have time for these smaller companies. I love being able to talk about it here on the channel though because mainstreet investors can use this as an advantage, getting in on the companies that fly under Wall Street’s radar.
Our third penny stock is Amira Nature Foods, ticker ANFI, a $57 million packaged food leader in specialty rice. Rice is the primary staple food for over half the world’s population with more than 512 metric tons consumed annually. The industry is extremely fragmented with the top ten brands controlling less than 13% of the market so this is an industry with a lot of room for consolidation and where bigger players can get an advantage.
ANFI books half its sales within India and another 44% in emerging Europe and the Middle East but has a distribution agreement with Whole Foods and Costco to sell in the U.S. market.
Amira is an extremely small company but what put it on my radar is that it’s a net current asset value stock. You might remember we talked about the NCAV in our video covering strategies from the book The Intelligent Investor. This is where a company’s current assets, so just its cash and receivables that can be converted quickly to cash, are more than all it’s liabilities both current and long-term. Basically, it’s a liquidation value of the company.
That’s $492 million in current assets minus $294 in total liabilities for Amira so a net current asset value of almost $200 million. Now when we compare that to the total value of the shares traded in the market and a market cap of just $57 million, you see how there could be some huge potential value here. Basically, someone could buy the company for under $60 million and sell the assets for two hundred. That’s something that can bring out big corporate buyers and it could mean a big jump in the shares.
There’s a lot of potential in those three penny stocks but don’t miss those three investing strategies I shared in our Intelligent Investor review. This is the book Warren Buffett called, by far the best book on investing every written. Also make sure to let me know in the comments if you want to see those videos on how I pick stocks from a fundamental analysis perspective.