Whenever you tell someone that you are interested in investing in small cap stocks (aka Penny Stocks) 9 times out of 10 you get a look of derision from whomever you are speaking with. Many people immediately think you are bonkers for choosing to put your money into this area of the market and assume that you are on the fast track to the poor house.
In many cases penny stocks are penny stocks for good reasons and the vast majority of them will never amount to anything in the long term. Many people will lose money if they choose to buy penny stocks, but that is because they really don’t know what they are doing and they don’t have a plan of when to enter, when to hold and when to exit a position.
A Quick Stock Market Lesson
There are two main things that people always get wrong when it comes to stocks, which both annoys and frustrates me. So to clear things up I will go into them here:
Share price and value
Let’s compare two stocks which are both listed on the Australian Stock Exchange (ASX) ILUKA RESOURCES LIMITED (ILU) and FORTESCUE METALS GROUP LTD (FMG). Both are resources companies and both are in the ASX top 50.
As of last weekend this was what each companies share price was:
- ILU – $10.57
- FMG – $3.51
Let’s talk value – The one with the highest share price is obviously the more valuable one right?
Wrong, in this instance you can’t tell just from the information that I have provided you. Let’s dig a little deeper.
The next thing I want to look at is how many shares each company has on issue.
- ILU – 480 million
- FMG – 3,113 million
We can now see that FMG has just over 6 times the amount of shares on issue than ILU does. This then impacts on the total market capitalization which we can now look at as we have enough information.
- ILU – $4,426 million
- FMG – $10,929 million
Now you can easily see which company is more valuable, and it is actually FMG which is about 2.5 times more valuable than ILU, despite it’s share price being 3 times larger. So as you can now see, just because a stock has a low price, it doesn’t mean it is a bad company or worth any less than a stock with a bigger share price. The actual price of the stock has limited value when it comes to your investment decision.
Return on Investment
My next point of contention is in regards to making a profit and so let’s dive right into my example.
Say I have $10,000 in each of the two stocks below:
- NEU whose price is $0.05 (Yes, that is 5 cents not $5) which I will have 200,000 shares for my $10,000
- TLS whose price is $5.00 ($5 not 5 cents) which I will have 2,000 shares for my $10,000
Now if the share price of both of these stocks increases by 1 cent which one generated the most profit?
You might be surprised to learn that many people think the profit generated on each stock is the same. I have even had heated arguments with people trying to explain the way it actually works. The truth is as follows:
- NEU generated $2,000 profit by moving 1 cent (200,000 shares x $0.06 = $12,000)
- TLS generated $20 profit by moving 1 cent (2,000 shares x $5.01 = $10,020)
So as you can see, just because they both went up 1 cent, the profit generated is VERY different.
Why I Choose Penny Stocks
The biggest reason why I choose penny stocks is because I can make a far greater returns on my investment in a smaller amount of time. The risk that a company might not make it big in the long term doesn’t both me, because most of the time I am in and out of a stock within a few weeks or whenever I have made my set amount of profit (normally 10-15%).
The biggest trap that most people get caught out with in penny stocks is that they treat them like larger stocks which you can set and forget. Pennys are not like that and they will take your money every time if you aren’t ready to actively manage your portfolio.
Have you been caught out by penny stocks or do you embrace them and the larger returns like I do?