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How to Identify Poor Quality Penny Stock Companies

With lower-priced shares, the proportion of lower-quality penny stock companies is greater than compared to high-priced and blue-chip stocks. And although the winners among penny stocks could produce gains dramatically higher than anything you would ever see among large cap companies, you first need to be able to identify and eliminate the types of companies that may be lackluster investments.

Typically, about 95 percent of shares trading below five dollars are financially weak, have questionable or unproven management, are not seeing market share growth, or hold important intellectual property.

A good story

A very compelling and exciting story motivates traders to buy shares in a company, with no thought to financial strength or appropriate stock price valuation. These good stories are the main reasons investors lose their money.

Examples of tall tales in penny stocks which cost their investors 100 percent of their investment within months, include

  • A car engine that runs on gravity

  • A water box that converts salt water to fresh water.

  • Drugs or treatments that may come close to curing some major disease

  • The world’s largest gold find

  • A beneficiary of legalized marijuana

  • An all-natural, healthy energy drink

  • Just about any business story behind the latest pump-and-dump stock promotion

The old phrase, “if it seems too good to be true, it probably is,” couldn’t be more applicable here.

Financially broken

In penny stocks, it is very common for the companies to be financially broken. They are crushed beneath debt loads so large that they can't even possibly pay the interest expenses, let alone the principal. They are often bleeding cash, with losses of millions of dollars more than they ever can hope to make in revenues, even if everything went right for them for the next five years.

As soon as a company is financially broken, it makes more sense for it to go bankrupt or close down operations than to try to resurrect the lost cause. Even if the business concept still has merit and there are individuals committed to making it work, their first step should be to let the corporation go under while they start up with a new entity that isn’t saddled by debt.

Weak business model

Some business ideas may make logical sense but in actual application are doomed to fail. No matter how great your marketing, or how popular your service, you can never make a business out of selling bags of dog food online. Nor would it work to offer over-the-phone surgery tips, or to provide security-monitoring responses by e-mail.

When the underlying business model of a company is questionable, it is doomed to failure. This is most true when a company incurs greater losses the more sales it achieves.

Swimming against the trend

A company on the wrong side of a social trend may be destined for failure. Companies selling cigarettes have been under dramatic pressure as smoking has been falling out of favor, especially compared to many years ago. The bigger players in the industry are only able to survive by branching out to alternative revenue channels and spending millions on advertising.

Picture instant cameras, which were completely wiped out by the rise in digital photography. Companies that specialize in fur coats can’t grow their businesses, no matter how aggressively or wisely they spend advertising dollars.

Be aware of social and industry trends that may affect a company, whether beneficial or detrimental. Smaller companies can benefit when trends go in their favor, but when shifts move against the company, the negative impact can often be serious. Penny stocks may try to adapt or sidestep any negative trend shifts, but they are often the victims when forces beyond their control change for the worse.

The 2-pound gorilla

You’ve heard the old joke. “Where does a 500-pound gorilla sit?” “Wherever it wants.”

Penny stocks can be worth a few million dollars, but their direct competitors may be worth billions. When a small penny stock is trying to function in an industry with much larger players, they need to be very careful.

As an investor you may want to avoid tiny companies that are at risk due to . . .

  • Rising competition: Whether the threat of new competition is in the form of brand-new companies entering the same space or massive corporations deciding to take over a new area, any time there is the potential for increased competition, smaller companies are put under major pressure. This becomes more of a problem when the barriers to entry to their particular markets are low.

  • Surrounded by direct competitors: Even if the competition is not new, the fact that there are currently many businesses fighting for market share means that all the players in that space face low profit margins, high advertising requirements, and constant customer attrition.

  • Specific workforce skill set: Any time companies rely on their employees for specific skills, competition for those employees can be fierce. Smaller companies in this type of situation are at a major disadvantage.

  • Legal and intellectual property (IP) maintenance: Larger corporations may spend only 5 percent of their revenues on legal fees or IP. Considering that the costs are set but that small companies have much lower revenue levels, the legal and IP costs are proportionately much higher. It is more difficult for that penny stock company to pursue the legal channels in disputes, even when it may be in the right.

  • Perception: Recognized names generally have an easier time attracting executives, staff, and customers. When a penny stock is new, or small, that lack of familiarity causes people to trust it less than they would a recognized name, which can put pressure on the company from numerous angles.

If the penny stock shows any progress, or gains any market share, larger companies can easily harness their resources to squash it.

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