How to invest in penny stocks

Any thoughts of investing in penny stocks requires investors to be willing to take greater risks than investing in bigger companies. The term penny stocks refers to companies whose market capitalization is at a level that is considered very small in relation to the average market capitalization of a publicly traded company.

Typically, penny stocks can be found trading on the smaller stock exchanges, though there some very small companies listed on the big exchanges like the Nasdaq as well. It is easy to forget that Microsoft too was once a penny stock when it first went through its initial public offering. Before investing in penny stocks, it is critical that you are fully aware of the possible risks and the objectives of investing in such stocks.

Penny stocks not for novices

• If you are new to investing in shares then you should stay away from investing in penny stocks because they involve too much risk for someone learning their way into the.

• Appreciate that there is far greater risk attached to investing in penny stocks than bigger companies. A small price movement would result in big changes in the value of your holding because the percentage change will have been a lot greater.

• Most small caps are not likely to pay dividends, as they are likely to retain any profit they make to reinvest in the business. Most penny stock investors understand this because they expect capital growth in the short to medium term, so the value of their holding will grow as the share price appreciates in value.

Researching penny stocks

Whilst there is plenty of information from financial data providers on big companies on their fundamental data and news flow, it can be extremely difficult to obtain such information on small companies, it is even more difficult on companies that are listed on the small stock exchanges. This is because not many analysts follow small companies.

• You should avoid any company that you do not have sufficient information on. Investing in companies on hunch is a recipe for disaster.

• There are still plenty of small companies that get good coverage from analysts and have their news tracked by wire services.

Day traders may use technical analysis to trade small companies. These can potentially offer very lucrative gains in very short space of time because change of a penny in the price of a penny stock often results in big paper gains, but conversely big losses if they go in the wrong direction than expected.

Purpose of investing in

The main reason for buying penny stocks or other very small caps is to be able to spot the next big company while it's still in its infancy, so to speak. The rewards can be enormous. Many people have become millionaires as a result of investing few thousand dollars in few tiny companies.

Now, they did not become millionaires overnight. They became rich through patience. They had to wait for the seeds to grow and eventually see it bloom into fully-fledged companies. In the process, they saw their once tiny holdings become something they could retire on, if they wanted to, of course.

Spotting the company of the future

While the purpose is to get in early and ride the crest of a wave, but spotting the next big company or companies is a difficult process.

• One way the great fund manager, Peter Lynch, used to help him give some inclination of whether to research a company further of its worthiness to invest for the future, was to see if it had particular products or services that everybody was raving about or had substantial competitive advantage over rival companies.

• Try to find small companies with breakthrough products/services, or companies with a competitive advantage over their rivals. Having a competitive advantage means they will have greater pricing power and more importantly, they will have more sales.

• Sometimes it can make sense to buy stock of small companies that are in a particular sector that is likely to be the “hot” sector in the future. Sometimes, many small companies just appreciate in value simply because they are in that particular sector, even though they may not be able to justify it from a fundamental standpoint. Having said that, you still should carry out thorough research on the company because companies that do not come close to be able to justify enhanced market capitalization, will only be able to sustain a higher share price for a while before spiralling downwards.

Making penny stocks part of your stock portfolio

For some people, making regular investments in equities is way of diversifying their assets and hoping to make better use of their money rather than leaving it all in savings accounts. As part of your overall stock portfolio, you could try to invest in a few very small companies, as long it is thoroughly researched and worthy of investment, to add some growth stocks to your overall portfolio.

Process of buying penny stocks

The actual process of buying penny stocks is exactly the same as buying the stock of any other company. It requires that you have a share dealing account, either a traditional stockbroker or an online broker.