A lot of people, finance professionals/academics and amateurs alike, will tell you that investing in penny stocks is inherently and necessarily risky, primarily by virtue of generally having small market capitalizations (e.g. below $100 million) and low stock price (e.g. below $5 in the U.S.) As I mention in all of my reports and articles on penny stocks, the lower the price, smaller the market cap, and lower the trading volume, the more susceptible the stock is to manipulation by unscrupulous types, typically using so-called “pump & dump” or “short & distort” schemes. Luckily, these risks can be minimized by using stop/limit (instead of market) orders along with proper position sizing relative to average volume to limit your downside risk and/or lock in profits. This, however, is not a column about trading (although that’s part of the process), it’s about fundamentals of business and investing, and that’s where I want to focus today.
So, now that we know how to (try to) minimize our risks on the trading side, how do we manage the risks associated with the underlying business? First, it depends on how one defines risk, or more accurately, what risks one is able to identify. Just because a penny stock is a small/micro-cap and/or development/transformation stage company doesn’t mean you can’t apply some of the same analytical techniques we use for larger companies to identify risks and determine if a given stock is worth your investment dollars. Interestingly, even the SEC has this to say about the risks of micro-cap stocks, emphasis mine:
“While all investments involve risk, microcap stocks are among the most risky. Many microcap companies tend to be new and have no proven track record. Some of these companies have no assets or operations. Others have products and services that are still in development or have yet to be tested in the market.”
This is a bit of an overgeneralization lacking nuance, but many penny stocks are fundamentally quite similar to the private early-stage companies that venture capitalists and angels invest in; The SEC’s comments could easily apply to both early-stage public and/or private endeavors. Harvard Business School senior lecturer Shikhar Ghosh has some very interesting stats and perspective on start-up/early-stage business failures. Barring outright fraud (more on this later), the reasons and frequency cited for business failure are probably not too much different for early-stage public firms than for private ones (not sure of data on this, but that’s the topic for another article).
So, how do we determine if it’s worth investing in a given penny stock? Generally, I prefer a primarily bottom-up approach with a healthy amount of deference to the top-down, regardless of market cap, and I think such a combination works especially well for penny stocks. Recently, a client hired us to research a volatile micro-cap penny stock, Nuvilex (NVLX) . I’m not going to get into too much detail about the specific project, but I want to use the company/research approach to illustrate how disciplined investors can separate the wheat from the chaff when it comes to penny stocks.
At first, I was skeptical of Nuvilex (not a surprise occurrence as I’m a skeptic first all the time); micro-cap stock, very volatile, very low price, barely any revenue, generally terrible financial statements, and a strange operating history spanning a decade and a half. The more research I did, though, I realized – again, barring outright fraud – the company’s technology has enormous potential. A simple Porter’s Five Forces analysis is always a good way to start, on any stock/company, again any market capitalization.
On a 1-10 scale I’d give Nuvilex a 7.5-8.5 on the five forces based on the public information I’ve reviewed. Regardless, this company, on a stand-alone basis, could change the way cancer, diabetes, and other horrible diseases are treated if not cured. Additionally, it’s a play on the inevitable paradigm shift in medical technologies coming from cell therapy and stem cell advancements. Bottom-up meets top-down; easy, right? Wrong!
Just because from 30,000 feet everything seems promising, we have to get a little closer to ground level, lest we miss something obvious like shady management, impossible financials, etc. I actually found it somewhat reassuring to see Nuvilex’s financial statements seem accurate compared to the story woven by management; many pump & dump, “fraudcap” (colloquialism for fraudulent or otherwise questionable micro-cap stocks) companies file SEC reports that make absolutely no sense given the market/industry and the idiosyncratic attributes of the company in question. Nuvilex’s tech has intellectual property protection, plenty of publications, accomplished leadership, and technology that could help extend if not save lives. When I was looking for competitors, I found one that explicitly disclaimed responsibility for all IP violations and said any issues were their customers’ problem. Amazing, no? Moving on…
The key takeaways here are 1. Don’t judge a book by its cover (or a stock by its price/market cap, 2. Most people don’t have a clue about investing (even some professionals), so beware word of mouth “advice,” 3. Always do your diligence and be on the lookout for shady #’s and characters; if it seems too good to be true, it probably is.