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One rite of passage for a lot of investors is buying a penny share. The logic is that even if it goes up only by a modest sum in absolute terms, the investment return could be great in percentage terms.
Here are a few questions I think any savvy investor should ask before even considering buying any penny share.
Do you like the business – or only the share price?
People who otherwise make many smart decisions sometimes buy penny shares just because they are penny shares – without understanding the business concerned in detail.
I think it is impossible even to try and ascertain the value of something without understanding what it is.
In my opinion, an unattractive business does not become attractive just because it trades as a penny share.
What competencies has the company demonstrated?
A lot of penny shares have what can seem like a compelling asset (or assets). For example, it might be a block of land potentially stuffed full of minerals or an entitlement to royalties.
But assets are only part of what makes for a compelling business. It needs competencies too.
What do I mean by that? Consider a company that has mining rights to a large area in a developing country.
The asset is clear. Like many such penny shares, it may lack diversification, but some such assets on their own can still be very valuable, in theory.
But who will do the prospecting? How will any minerals found be extracted? How will the company navigate mining law, government negotiations, export licenses, finding buyers, and myriad other practical issues?
Such competencies can usually be bought in. But before buying a penny share I like to assess whether I think a company has the skills, or most of the skills, to try and achieve what it aims to do.
Is there any proven profitability?
I also try to focus on how the company has already demonstrated it can make money, rather than just theoretical claims about how it could potentially make money in the best of all possible worlds. Ideally, (though this typically will not work for natural resource prospectors without commercialized projects) I look for hard evidence of profitability.
For example, one of the few penny shares in my portfolio is Topps Tiles (LSE: TPT). So far, it has been a very disappointing shareholding.
However, I have kept faith with the investment case for several reasons. One is that Topps has proven it can make money by actually doing so. For the first half of this year, for example, it reported £1.9m of profit before tax.
Topps also has the necessary skills for its business and has tried to plug some gaps. For example, it bought some of the assets of a collapsed rival to try and gain better exposure to the professional market of tile purchasers or specifiers, such as architects.
The business is one I like – in fact, the current share price is what I do not like about this penny share!
Partly, that reflects various risks for Topps. An uncertain housing market outlook is one of them, threatening to cut demand for tiles.
Topps has not been a rewarding investment for me so far, but I am still glad I asked myself the questions above before buying.
This story originally appeared on Motley Fool
