What is a ‘penny share’?
There’s no hard-and-fast definition. But broadly speaking, the term describes just about any stock that has the potential to make you a lot of money. There’s a sense of risk, but also a sense of excitement to investing in this area of the market.
Typically, you’ll find that penny shares tend to come in two main types. There are relatively small, youthful companies – ones with the potential to grow enormously. Then there are companies that have low share prices – hence the term ‘penny’ stocks. And many companies might fall into both categories.
Of course, not all smaller companies become successful – many amount to nothing – but those that do can make investors a lot of money. So how do you identify the ones that are likely to succeed, and weed out the no-hopers?
Let’s look at young companies first.
How a start-up becomes a household name
All big, successful, blue-chip companies start out as someone’s bright idea.
To become successful companies, they typically have to go through four phases:
The company is little more than an idea. This is the riskiest time to invest, but potentially the most profitable.
The early excitement of an idea gives way to real-world problems during this phase, which is all about actually getting a product out of the door. There may be development delays and funding requirements. This stage can be difficult for investors.
The company’s product has reached the market and is selling well. More investors commit their cash, and word spreads about the company. This is a good time to be an investor.
Everyone who wants the product already has it. Competitors may have emerged, or the product may have been superseded by a newer technology. The rapid growth phase is over.
Unfortunately, no-one tells you that you are in this final stage – you have to work it out yourself.
The trick to success is making sure you stick with a share long enough to profit, but not so long that prospects get stale.
New companies come along all the time
The stockmarket has two purposes: one is to provide a marketplace where investors can buy and sell shares.
The other is to help companies raise funds. Companies can sell a share in their business to investors in return for the money that will allow them to enact their strategy. It’s just like the BBC TV programme, Dragon’s Den.
Every year, many companies come to market, listing on the stock exchange, usually to raise new capital. They need this money for lots of different reasons: to build infrastructure, to enable research, to hire a marketing team, or to buy raw materials. A miner might need the money to dig a hole. A manufacturer might want it to invest in new machinery.
All this means that there are always plenty of opportunities to get into new companies.
So that’s an overview of young companies and the most interesting phases of their growth. What about the ‘penny’ aspect of ‘penny shares’?
How to ‘buy low’
When trading penny shares, it’s worth keeping in mind that the actual price of a single share tells you nothing.
The share price is simply the value of a company divided by the number of shares in issue.
Imagine two companies, both with a value of £1m. One company has 100 million shares in issue, but the other has only 100,000. Many investors would rather own 1,000 shares in the former than one in the latter – but there’s no logical justification for this.
When companies come to market for the first time, they set their own share price (altering it simply by issuing more or fewer shares). In general, companies in the UK will choose a relatively low price, often below £1. If a share price is £5 or £10, it has probably risen over time from a lower level.
That said, there is no reason why it should not continue to rise, though clearly an investor would rather have bought it at 50p than at ten times that price.
By sifting through low-priced shares we are more likely to find shares that have yet to make a major move.
Alternatively, we might find shares that have fallen in value having traded at much higher levels. These are ‘recovery stocks’ – shares that have fallen in price, but which have the potential to recover to their original level.
After all, life in business isn’t simple – just like real life. Companies are affected by events beyond their control as well as internal problems that are allowed to get out of hand through neglect, bad luck or poor communication. The interest rate cycle is a good example of an external influence that can have a major impact on most companies.
Take housebuilders. Their profits are of course directly related to house prices – if interest rates rise, house prices tend to fall. Under those circumstances, there’s not much a housebuilder can do except try to weather the storm. But this can present opportunities for an investor.
You see, plenty of housebuilders have their shares quoted on the stockmarket; when the cycle naturally pulls their share prices down, it might give us a good opportunity to buy them and benefit from the subsequent recovery (which is also part of a cycle).
Monitoring this type of external pressure on a share price is relatively easy. The internal goings-on of a company are much harder to gauge. Company directors do not always do obvious – or even sensible – things.
They might fall out with major customers; they might have staff poached by a rival; they might see a better-funded product make their own product obsolete; an important customer might go bust without paying a bill. But in my experience, the two most common internal problems are duff deals and unfulfilled expectations.
When private companies choose to have their shares listed on a stock exchange, they have to employ various highly-paid advisers. Unsurprisingly, these advisers are eager to extract even more fees after the listing is complete. Nothing generates fees more than an acquisition. So, City advisers push for such deals. All too often directors jump at the chance, proud to be at the top of a listed company, eager to stamp their mark on the corporate scene.
To listen to the pen-pushers and number-crunchers, you’d think that merging two companies is a piece of cake. But mergers aren’t just done on paper. As well as a lot of work, and a well-considered strategy, mergers take considerable diplomacy to ensure that staff and customers stay on-side. Company cultures can and do clash; this is one of the most common causes of shareholder disappointment.
The stockmarket throws up many opportunities to buy at bargain prices
A share price always incorporates a set of expectations. These expectations are ‘in the price’, as the City jargon puts it.
For example, the City expects a company to deliver profits as forecast, and to progress at a certain rate. The fact that business life can be rocky doesn’t factor in to the views of brokers and investment managers. They expect companies to deliver, and that is that. If a company dares to admit that it might fall short of forecast profits, or that it has slipped a few months behind schedule, the City turns its back and the share price plummets.
Woe betide a company that falls short of expectations! This is a horrible time to be holding the shares.
But for those not holding shares, this can be a great time to buy in at a low level, and to benefit from the subsequent recovery as the company gets back on track.
There are always opportunities to buy shares at a low level. Taking the best of these opportunities will enable you to profit either from the subsequent growth of the company or from its recovery.
To give you an idea of just how deep the pool of penny shares is, take a look at this table:
|Value of company||No of companies this size||Aggregate value||% of total stock market|
Source: London Stock Exchange main market and Aim fact sheets, September 2014
In short, it doesn’t make sense for institutional investors or funds to waste their time looking at companies that are simply too small to absorb more than a tiny proportion of their capital. Around 85% of the combined value of the near-2,000 companies quoted on the stock exchange is accounted for by the 142 largest. But the smallest 1,428 companies account for just 3.2% of the total combined value.
In other words, there are hundreds of companies that are largely ignored by professional investors, who simply have too much money under management to bother even looking at these companies (because they can’t own sufficient quantities of them to make any sort of significant difference to their own overall portfolios).
But there is nothing to stop private investors from investing in these small companies. And that’s one of the few places where we have a real advantage over the City boys. We don’t have to manage billions or hundreds of millions of pounds. (This is a factor often bemoaned by none other than US legend Warren Buffett, who’ll occasionally hark back to the days when his portfolio was small enough to allow him to contemplate smaller companies.)
If we’re prepared to do a bit of digging into little-known companies, we can gain an edge on other investors. And if these hidden gems do turn out to be successful, then eventually they’ll get big enough to attract the attention of the bigger players. That’s when a share price can really take off.
And that’s why the lower reaches of the stockmarket can be a treasure trove. There are some real winners in amongst those small caps. That list has companies from every sector: mining, electronics, medicine, property, food, retail, oil – and many more. You might even unearth the next Apple!
Moreover, that list is constantly refreshed. Each year hundreds of new businesses, both from the UK and abroad, choose to have their shares traded on the London Stock Exchange.
The lower reaches of the FTSE All-Share contain all sorts of companies, some destined for greatness and some doomed to fail. Your job as an investor is identifying which ones are which.
And remember, even the best investors take advice. If you’re interested in investing in penny shares, but want to build up your knowledge before you start, download our free report.
Category: Buying Aim Shares