10 Key Penny Stock Considerations for Companies - dummies

10 Key Penny Stock Considerations for Companies

By Peter Leeds

Although the share price of a penny stock is often dictated by the results of the company’s financial reports, those financial results are ultimately derived from operations. You need to pay close attention to a company’s operational factors and related concepts when making your investment decisions. The following ten key concepts can have a major impact on the success or failure of a company.

Barriers to entry

A barrier to entry is any issue or obstacle that a company must overcome in order to sell to a specific market. For example, if a company wants to sell a new prescription drug, getting FDA approval represents a barrier to entry. To open a factory in a town with a workforce shortage, a barrier to entry may be getting enough employees.

The higher the barriers to get involved in an industry or business line, the harder it will be for the company to get started in that space.

Barriers to entry can be based on many factors, including high regulations, lack of specialized workforce, governmental requisite approvals, pre-existing competitors, materials costs, and more. Anything that makes it difficult for a company to establish itself and sell specific products to a specific market acts as a barrier to entry.

Ideally, you want to invest in companies that are established and doing well in an industry with very high barriers. This limits the amount of new competition it has to face. Picture a penny stock with FDA approval for a drug that fights a major disease. The company has already cleared the biggest hurdle, and any companies looking to take on the same market will have to achieve the same clearance. And even if they eventually clear that barrier to entry, there may not be much market left.

Competitive advantages

A competitive advantage exists for a company when it finds itself in a beneficial situation not shared by its competitors. Picture a corporation that has better access to a skilled workforce, is able to produce products for less, or makes greater profits from its services.

Not every company has advantages over the competition, but the majority of businesses can point to at least a few ways that they have an edge. Corporations that leverage those advantages have the potential to do very well, especially in relation to their competitors who don’t enjoy the same benefit.

Look for penny stock companies that are aware of and leverage their competitive edge. Be cautious of those companies that don’t seem to be benefiting from any specific advantage, are not aware of it, or are not leveraging it to the fullest.

Market share (and room for growth)

Every company selling its products or services has a portion of the total available market. For example, if a penny stock sells half of the total worldwide stock of waffle makers, it has a 50 percent market share.

You definitely want to know what share of market a company enjoys, but you’re in an even better position if you understand whether that percentage is increasing or decreasing over time. Growth in a company’s total market share demonstrates expanding customer adoption of its services.

Ideally, you want to own penny stocks in growing industries that are also expanding their market share by taking business away from their direct competitors. As long as the company maintains those trends, and the industry maintains its growth, your investment could perform very well.

Customer diversity and the company’s reliance

Some companies have one or two customers; others have thousands. By having a greater diversity of clients, the company is insulated from shocks that can come from the loss of a few of them.

Contrast that with a military weapons designer with only two customers, both of which come from contracts with the government. If the government cancels one of its contracts, the event would decimate the company’s stock and possibly put it out of business.

For certain penny stock companies it’s just not realistic for them to have numerous clients.

You also want to beware of penny stock companies with many clients but that get a significant portion of their business from a small subset of those customers. Anytime a corporation is reliant primarily on a smaller number of customers, they are exposing themselves and their shareholders to risks.

Allies

Allies are more important with penny stock companies than larger corporations. When a business is in the early stages of its life cycle and is trying to survive, the advantages that strong alliances provide can have the greatest impact.

Some of the greatest companies of all time leaned heavily on their alliances with other strong players in their industry. With the right corporations, organizations, or individuals in its corner, a stock can advance very quickly.

Insider ownership

When executives and managers of a company own a high percentage of the shares, that’s generally a good sign. Called insider ownership, it means that management is financially vested in the fortunes of the shares and, as such, has an additional motivation for the company to do well.

Insider ownership positions, just like corporate financial reports, are a matter of public record. You can easily see the exact percentage of insider ownership from anywhere financial information is displayed.

Insider ownership of 10 to 30 percent is generally a positive sign. If that ownership percentage is increasing over time, that’s an even better sign, because it means that key players are accumulating shares.

You don’t want insider ownership to go too high, though. Avoid companies where a controlling percentage of shares, or close to it, is in the hands of the key executives. Any time insider ownership gets higher than about 30 percent, the key players will have a much easier time controlling the company. An ownership stake higher than 50 percent gives management the power to do whatever they like without fear of losing their jobs, which is not necessarily in the best interests of shareholders.

By watching for a healthy amount of insider ownership, with that amount increasing over time, you can know that insiders are committed to the company. While insiders are often wrong with their buying and selling timing, it can still add to your due diligence when analyzing any penny stock.

Institutional ownership

Companies must disclose the level of institutional ownership, or ownership by entities such as mutual funds, hedge funds, investment banks, and other professional investors. Many institutions can easily move around tens of millions of dollars with a single trade.

A very high degree of institutional ownership is a good sign, because it demonstrates that the stock is worthy of interest by professional analysts. When a top-level analyst working for a multi-billion dollar mutual fund buys 5 percent of a company’s shares, most investors believe that he did extensive due diligence and feels the shares are a good investment. Sometimes such actions turn out to be wise, but not always.

Keep in mind that most institutional investors manage hundreds of millions, if not billions, of dollars. They usually have restrictions on the size and types of the companies they can invest in, and they are rarely allowed to invest in penny stocks. Because of this, you will often see penny stocks with no institutional ownership at all, but that situation isn’t necessarily a warning sign or indicator that the company is a poor investment choice.

Positioning

Every company fights for a position in your mind. You may have opinions about which fast food tastes best, which cereal is healthiest, or which cell phone company provides the most reliable service. These companies hold a space in your mind, and even if your opinions aren’t right, you act as if they are.

When a company understands how it and its competitors are positioned in the minds of prospects and is able to adjust that positioning when necessary, their actions can have a significant, albeit somewhat intangible, advantage.

Consumers want to buy coffee from Columbia, wine from France, military items from America, and cigars from Cuba. Companies from these nations have a positioning advantage to sell the goods just mentioned when compared to purveyors of coffee from Canada, wine from Honduras, military items from Laos, and cigars from New Zealand.

When a penny stock is enjoying a strong position in the minds of prospects (assuming that position is a positive one), then it has a competitive advantage. If customers believe that the penny stock’s software is fastest, or its vitamins are least expensive, or its mountain climbing gear is safest, then they should see increased sales to anyone looking for the fast software, inexpensive vitamins, or safe mountain climbing equipment.

Look for penny stocks that hold a position in the minds of prospects or that are culturing and developing one. At the same time, avoid those penny stocks whose companies don’t seem to represent anything noteworthy.

The secret of flag fall fees

You incur an initial charge, called a flag fall fee, when you first get into a taxi. That fee is in addition to and independent of the subsequent distance charges.

Many industries charge flag fall fees. Any time a customer incurs a set initial fee, regardless of expenses thereafter that are based on time, distance, or amount, that is flag fall in action.

You may have been victim to flag fall already if you’ve set up a new mobile phone account. Most mobile phone companies require customers to pay “an account establishment fee” or “initial activation fee.” Every new customer pays out that amount, regardless of the phone plan they purchase or how much they use the phone.

Any penny stock that increases its flag fall rates without impacting its new client numbers should see a jump in its revenues. As long as the penny stock is collecting higher amounts as a means to increase profits or income, as opposed to being a desperation move due to financial issues, then that company may represent a strong investment prospect.

It’s all about recurring revenues and attrition

A company that enjoys recurring billing, such as monthly membership fees, is easier to analyze than businesses with unpredictable sales or no recurring revenues. If it charges ten dollars a month, and it doubles its subscriber numbers, you can anticipate that its revenues will also double.

Recurring revenues make it easy to analyze a company because you can know how much money will be coming in. As long as the company keeps its subscriber count growing, it should also grow as a company and see the benefits in its share price.

Anytime you’re looking at a business with recurring revenues, the most important factor is its attrition rate, which indicates how many customers it is losing. Ten percent growth in new subscribers is great, but not if it has a 20 percent attrition rate.