It is easy to understand why people like the idea of buying a share for pennies and watching its value soar. But while some penny shares increase in value many times over, others lose all value.
I do own some penny shares, such as Topps Tiles (LSE: TPT) and Gresham House Income & Growth Venture Capital Trust.
But owning such shares has been a mixed bag and there are a few things I particularly look out for when considering them. Here are three.
1. Company has zero revenue
Penny shares are sometimes sold to raise money for a company that has not yet started making any revenues. A common example is a business with a mining license that needs funds to help develop the site and possibly move to commercial production.
This is not unique to penny shares. Some large tech companies also sell shares to investors at what they call a “pre-revenue” stage.
For me, a company with no revenue is not a business so much as an idea. Maybe in future it will generate sizeable revenues and profits. But before it starts making any sales, I think it is difficult if not impossible to judge its business model.
Contrast that to a company like Topps. Its statutory revenue jumped 16% year on year in the first half, to £143m. The company sells one in five tiles bought in the UK.
2. Weak liquidity
Liquidity refers to a company’s access to the funds it needs to keep running its business. That could include cash on hand, bank loans or other types of debt.
When the economy goes south and lenders start to tighten their lending criteria (or sometimes go bust themselves) it can be bad news for businesses with financing needs and weak liquidity.
Large industrial giants like Associated British Foods or Shell may find it harder to borrow on attractive terms in such moments – but I do not stay awake at night worrying that their liquidity will dry up overnight.
That can be a real risk for penny shares, though, as many have limited funds on their balance sheet. Lenders may be more wary of advancing money to a business with limited revenues or profits.
That is one reason I explored Topps’ balance sheet before investing in it. A decline from £8.7m of adjusted net cash at the end of its last financial year to £1.2m of adjusted net debt at the half-year point was thus a concern to me.
The board noted, though, that it reckons Topps has sufficient available liquidity to continue to meet all its financial obligations as they fall due for the foreseeable future. I will be keeping a close eye on the company’s balance sheet.
3. No sizeable shareholders
With a big company like Alphabet I do not bother looking into who else owns shares. With its $2.3trn market capitalisation, I am confident that there are multiple shareholders with big enough stakes to pay close attention to how the company is being run.
This is sometimes known as “monitoring” and can be a problem with penny shares. A small market capitalisation can mean no large shareholder has a big enough financial incentive to monitor management closely.
That could happen at any business, but it is far more likely in small ones with fragmented shareholdings than very large companies.
