Learning how to pick a penny stock is quite a daunting endeavour. Quite often, these businesses will find their way into headlines, sending their share prices through the roof. Yet only a few months later, they crash straight back down again.
This has happened countless times, but two recent examples I’ve been following in 2021 are Kanabo and Novacyt.
Today, these companies trade for a fraction of their share price compared to 12 months ago. Both of these traps were avoidable. And in my case, eliminating them from my potential buy list was relatively easy by applying two simple rules to picking a penny stock. Let’s take a look.
#1 Don’t pick a penny stock with no revenue
One of the most potent catalysts for growth in young businesses is a breakthrough technology or achievement. There is an endless list of companies looking to disrupt their respective industries with a new approach or product. And these are the sorts of milestones that make it into headlines, getting the investment community understandably excited.
But having a working revolutionary product is only half of the puzzle. The other half is its financial viability and whether management has the resources to deploy it at scale. This is precisely what happened with Kanabo.
The medical marijuana company received a lot of hype for being the first of its kind to become listed on the London Stock Exchange. And this hype continued after its pilot programme was successful. But scaling manufacturing and sales channels is not exactly easy. And 12 months on, the group has yet to generate any meaningful revenue. Hype dies a lot faster than that and, subsequently, the penny stock tanked.
#2 Don’t pick a penny stock with only a handful of customers
Not all penny stocks are pre-revenue. But that doesn’t mean the business model is sound. Young businesses are often dependent on only a small number of clients. This is a big reason why the risk profile is typically much higher than a more mature enterprise.
But sometimes these dependencies can be extreme. As was the case for Novacyt. The medical diagnostics group was one of the first to produce a working Covid-19 lateral flow test. Given that demand for these tests was through the roof in 2020, its revenue stream exploded.
The problem was that around half of this newfound growth came from a single customer – the UK Department of Health and Social Care (DHSC). So, it’s hardly a surprise that when its contract with the DHSC wasn’t renewed, a massive chunk of its income was wiped out, taking the penny stock with it.
Final thoughts
This checklist is by no means a complete solution to picking winning penny stocks. There are many additional factors to consider surrounding long-term potential, competitive advantages, and general financial health. But in my experience, these two criteria are an effective method of eliminating poor investment decisions.
