‘Penny shares’ is a loose term that broadly speaking applies to any share that has the potential to make you a very large amount of money. Of course they will not all succeed, but they do at least offer that possibility. The shares that I write about in Red Hot Penny Shares really fall under two definitions. Either they are young companies that could achieve rapid growth, or else they have a low share price. Or both!
Young companies
All of today’s big companies started out long ago as somebody’s good idea. They will typically have gone through three phases.
First of all there is the development phase, during which the good idea is converted into a successful commercial product. Next comes the growth phase. By now the product is established. It is selling well and in increasing numbers. Finally the company reaches maturity, taking us into phase three. Now every possible customer for the product has already bought one; competition may have emerged; or the product may have been overtaken by a new technology.
When I refer to young companies, I mean those in phase one or the early stage of phase two.The trick is to get into a growing business late enough to be convinced that it will succeed, but early enough to capture all that growth. There are hundreds of early stage companies quoted on the stock market, as there should be! Because the stock market has two purposes: one is to provide a market place where investors can buy and sell shares; the second is to allow companies to raise money. They will sell a share in their business to outside investors in return for the money that they need to progress their plans – exactly the same thing that happens in the TV show Dragon’s Den.
Every year many companies choose to list on the stock exchange, usually in order to raise capital.They need this capital for all sorts of reasons. To build a factory; to progress their research work; to hire a marketing team; or to buy the raw materials that they need, for instance. In the case of mining ventures they need cash in order to dig the holes in which they might find precious metals. So the opportunities to get into new companies are several, and come in a constant stream.
Low share prices
Suppose that a share in company A costs you a penny. But a single share in company B costs £10. So you can buy one thousand shares in the former for no more than the cost of one share in the latter. Many people would rather have one thousand shares in a company than just one. But this is a common misconception. The actual price of a share tells you nothing. The share price is simply the product of the number of shares in a company and its value. Company A and B might both have a value of £1m.The only difference is that company A has one hundred million shares in issue, but there are only one hundred thousand shares in company B.
All the same, when companies come to the stock market for the first time they can set their own share price (altering it simply by issuing more or fewer shares) and they generally choose a price that is below £1. So if a share price is £5 or £10 the chances are that it has got there by going up over time from a lower level. There is no reason why it should not continue to rise, but clearly if a share price has moved from 50p to £5, one would rather have bought it at 50p than to be buying it now. So by sifting through low-priced shares we are more likely to find shares that are yet to make a major move. We are also likely to find shares that have previously been trading at much higher levels. This brings us into the realm of ‘recovery stocks’.
‘Recovery’ stocks
Corporate life never runs smooth. All companies are affected both by external events that they cannot control, and internal events that they could control but do not necessarily do so very well. A simple example of the former would be the interest rate cycle, which affects house prices.
The profits of companies that make houses are directly related to the prices at which they can sell them. So if interest rates rise and house prices consequently fall, there is not much that a house builder can do except sit and suffer. Plenty of house builders have their shares quoted on the stock market, and as the downswing of the cycle brings their share prices to low levels we are presented with a good chance to buy them and benefit from the subsequent recovery.
This type of external pressure on a share price is relatively easy to spot and to monitor. Far more difficult are happenings within a company. Unfortunately, company directors do not always do predictable things, or things that are very sensible.They might fall out with their major customer; they might see their key staff depart for a rival; they might fail to invest in their product and see it overtaken by a competitor; they might find that a customer cannot pay their bill. But the two self-inflicted wounds that are most common are duff deals and unfulfilled expectations.
When private companies choose to go public and have their shares listed on the stock exchange they are obliged to employ various highly paid advisers. Once they have achieved this new status they find that these advisers are only too keen to extract even more fees. Nothing generates fees more than a deal in which one company acquires another. So City advisers promote the idea of such deals and all too often they find that the directors, proud of their new status in charge of public companies and fancying themselves as gladiators of the corporate scene, are ready to listen and to act.
Listen to those who have never got outside the world of spreadsheets and financial forecasts and you would think that merging two companies together is a piece of cake. But in reality it involves a lot of work, a very careful plan, and above all considerable diplomacy to ensure that staff and customers go along with the idea. All too easily things can go wrong, and this is one of the most common reasons why the high expectations of shareholders can be disappointed.
It is absolutely vital to understand that a share price at any time incorporates a set of expectations. And nothing upsets the City more than a company that falls short of these expectations. The City expects a company to deliver the profits that are forecast, and to progress at a certain rate.The fact that business life never runs entirely smooth and according to plan does not seem to occur to brokers and investment managers. They expect companies to deliver, and that is that. So if a company dares to admit that it might not quite make the forecast profits, and might have slipped a few months behind schedule then the wrath of the City descends upon it and its share price is sunk. If you hold shares in the company at this time you suffer. But if you do not hold shares then this can be a great time to get on board. You can buy the shares at a low level, and benefit from the subsequent recovery as the company gets back on track and City sentiment thaws.
So the stock market is continually offering you and me the chance to buy shares at a low level. And if we take the best of these opportunities we will profit either from the subsequent growth of the company or from its recovery.
To give you an idea of just how deep the pool is in which we can fish, take a look at this table:
| Value of company (£) | No. of companies this size | Aggregate value (£m) | % of total stockmarket |
|---|---|---|---|
| 0-5m | 374 | 934 | 0.05 |
| 5-10m | 247 | 1,805 | 0.1 |
| 10-25m | 398 | 6,589 | 0.4 |
| 25-50m | 297 | 10,794 | 0.6 |
| 50-100m | 237 | 17,004 | 1 |
| 100-250m | 266 | 42,478 | 2.4 |
| 250-500m | 164 | 56,975 | 3.2 |
| 500m-1bn | 88 | 63,891 | 3.6 |
| 1bn-2bn | 76 | 106,819 | 6 |
| 2bn+ | 102 | 1,469,979 | 82.7 |
| Total | 2,249 | 1,777,268 | 100 |
What this shows is that 82.7% of the combined value of all the 2,249 companies quoted on the Stock Exchange is accounted for by the 102 largest of them. But at the other end 1,553 companies account for just 2.1% of the total combined value. So there is a very long tail of small companies, all largely ignored by professional investors. Remember, professional investors have billions of pounds to invest. So it just does not make sense for them to waste their time looking at companies that, however attractive, are simply too small to absorb more than a minute fraction of their funds.
But there is nothing at all to stop private investors from investing in these small companies. In fact it makes perfect sense. By doing a bit of our own research work we can gain some competitive insights. And we know that if our chosen companies are successful they will graduate up this scale until eventually they are large enough to attract the attention of the pros.
This is a real treasure trove. Amongst these several hundred small companies are some real winners. In fact amongst them could lie the next Google and the next Nokia! Within this list we will find companies from every corner of commerce. Mining, electronics, medicine, property, food, retail, oil – and many, many more. And it is a list that is being constantly refreshed. Each year up to three hundred new companies, both from the UK and from overseas, choose to have their shares traded on the London Stock Exchange. To give you a flavour, recent new listings have included a company proposing to grow palm oil Liberia, another looking for gas in New Zealand, and third perfecting ways of delivering medicines in the form of chewy confectionery.
The question, then, is how to select the good ones.
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