In for a Penny

The recent bear market, accompanied by stock market volatility, has sent investors fleeing to defensive stocks. Food retailers and banks have seen the lion's share of the action, leaving tech stocks and other speculative sectors out in the cold. However, many of the FTSE 100 stocks are now trading at a fair value. The market is more likely to track sideways, at best, than to deliver any significant gains. But there are still some good growth opportunities to be found in unpopular stocks and, in particular, penny stocks.

Oversold or overvalued?

Penny stocks (stocks trading at a fraction of their historic highs) are often perceived by the majority of investors to be no-hopers. The reason they are so unpopular with investors is that they offer little or no prospect of recovery, even when market conditions improve. Some tech stocks--or dot.coms with unworkable business models--may fall into this category. While not all penny stocks will shoot up in value like this, there are many penny stocks that are oversold, and are not trading at a fair value. So why is this the case?

Some penny stocks have fallen to a low price level because they are likely to run out of cash before they are able to reach a cashflow neutral position. This is often the case for technology businesses, of which Scoot.com is a timely example. In these cases share dilution is an important issue. Many penny stock companies would like to raise capital through issuing additional shares but they can only do this by offering a discount to an already low share price. Therefore, in order for a rights issue to raise sufficient funds, a significant number of shares need to be created which will severely dilute the value of the original equity. In many cases, the low price of penny stocks reflects this fact. But why then should these penny stocks be considered oversold? Aren't these companies just trading at a value that reflects the fact that their growth opportunities are severely limited?

Not necessarily. There may be purely technical effects at work which are preventing stocks with real growth potential from rising in price in the near term, especially in today's bear market. Once a company's market capitalisation falls below a certain arbitrary level it drops below institutional radar screens, and so can become poorly researched, contributing to a lack of investor interest.

In general, pension funds and financial institutions are not prepared to look at `tiny' companies trading at very low levels. This is because even if the stocks do perform well, any gains will be so small as to have a minimal impact on the overall value of their portfolio. It is, therefore, not worth the time and effort involved to research them. As a result, very few new institutional buyers will be interested.

For those already holding the shares, institutions will often dump stock when the value of the shareholding becomes very small in relation to other holdings. However, the institutional assessment doesn't always reflect the true value of the company, which gets caught in a technical downward spiral, ending up at an undervalued level. This is where the clever investor can find interesting opportunities. As the market rebounds or a company achieves particularly good results, it will attract analyst coverage. This will then attract institutions to the growing company, often resulting in a rise in its share price, which may in turn push the company back into an index such as the FTSE 250 or All-Share. The shares will then be bought up by tracker funds, which will push up the share price even further. The trick then, is to get in first at the bottom of this virtuous price spiral.

Rollercoaster ride

So, penny stocks can be an attractive investment option. However, they can also be highly volatile: A share priced at 10p may rise 50 per cent or more on the back of good news or a tip-off from a broker or investment publication, or on speculation of a takeover. This is one of the main rewards of investing in such speculative stocks. However, the share price can also plummet by a similarly dramatic amount if results are poor.

This volatility is also a consequence of a thin trading market in the shares. Penny stocks can be difficult to buy and sell, as there will be fewer market makers, each dealing in small quantities of the stock. This is a two-fold problem, as it may make it difficult to buy the shares when the price is rising, and difficult to sell when the share price falls.

An indication of this lack of liquidity, as it is known, is the difference between the bid and offer price of the share; the `bid' being the selling price and `offer' being the buying price. If this difference--known as the spread--is wider than average, it may indicate that the share is traded infrequently, thus increasing the risk of volatility. Furthermore, the wider the spread, the more a share price has to perform in order just to break even. This is because the spread causes an inherent loss at the time of the transaction. Therefore, if you buy a penny stock that is at a bid price of 40p and an offer price of 50p, then the mid price would have to rise by 25 per cent just to recover the initial purchase cost. It is essential to check for the size of spread when considering penny stocks, as although the spread for these shares typically ranges from 25 to 35 per cent, it can sometimes be as wide as 50 to 100 per cent--or occasionally even more than 100 per cent. Such stocks would have to outperform spectacularly to make a profit.

Cover Your Backs

An investor can minimise these risks, however, by buying a basket of penny stocks rather than picking only a few, or investing in a fund that is willing to look at out-of-favour sectors and penny stocks. This way, in the mid- to long-term, although some stocks may fail to recover or fluctuate massively in price, others may dramatically outperform the market. Even so, it is still important to pay attention to specific company characteristics. What, then, should investors look out for?

Just because a company is trading at a low share price, this is not necessarily an indicator of growth potential, especially in the case of dot.coms where many business models remain unproven. Stock watchers should continue to look to the fundamentals for guidance. A company should have the ability to deliver strong sales growth--either because the market for their products or service is growing strongly, or because they are gaining market share at the expense of their competitors.

Unfortunately, accessible information about penny stock companies tends to be limited, as these companies do not have huge budgets to market themselves, their products or business objectives. This is another reason why the less experienced investor may prefer to invest in penny stocks indirectly through a collective investment, as it can be difficult to find enough information to make an informed decision on a particular stock. However, it is possible to find information about particular companies on the OFEX and AIM websites, as many penny stocks are listed on these exchanges.

Along with a sound business outlook, healthy balance sheets and cash flows are also crucial in determining lower investor risk. A high level of free cash-flow is desirable because it translates directly into a strong balance sheet. Crucially, it provides a company with the means to finance new growth without recourse to shareholders, or indeed, to debt. Small companies cannot get such favourable loan terms as larger companies, meaning that gearing is relatively more expensive and may negatively impact on the companies' performance. Strong cash flows can indicate that a company has a sound business model and is less risky than companies that are highly leveraged. Good examples of this type of penny stock might be Senior plc or Sibir Energy--both companies offer good prospects.

Investors must remember, however, that even the most outwardly promising penny stock company may not fulfil its potential, and may not last the distance in the long-term. Penny stock investing is highly speculative. However, as part of a diversified and balanced portfolio there are many penny stocks--particularly in the tech sector--which are technically depressed and offer good value, especially in the mid-term. Arcadia is a classic historic example of a former penny stock that was buffeted by the market and technical effects, but actually had the potential to recover and rebound. Although not all penny stocks can, or will, do as well as Arcadia, it is certainly worth rummaging in the bargain bin for some gems--or at the very least getting a fund manager to do it for you.

Paul Mumford is senior fund manager at Cavendish Asset Management and fund manager of the Cavendish Opportunities Fund (www.cavendishassetmanagement.com)

Paul Mumford