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The ‘must know facts' about penny share investing

by , 07 January 2016

Over the last three decades, the small-cap sector (which houses ‘penny shares') outperformed nearly every other market by a landslide.

In fact, if you had spread R10,000 across the entire small-cap universe in 1996, you would have turned it into R171,021.60 by 2015.

And since 1929, the average annual return on small-cap stocks has been 11.9%, according to Morningstar Ibbotson data on international indices.

That's enough to turn a simple R10,000 investment into well over R160 million, compared to just R31 million for large-cap companies in the same time frame.

But those are just your average returns — mere chump change to small-cap investors who know how to weed out the losers and pick the winners.

This is a market filled with underdogs and hidden champions. It's a space where the average Joe can turn a small investment into a massive fortune with just one or two multi-baggers.
 
Of course, people don't simply get rich by picking stocks at random. You need to know a few things about this industry before diving in.

Why I put my money into small cap shares

There are a number of reasons why small caps consistently outperform competing sectors:

•    It’s easier for small-caps to grow faster

 It’s much easier for a small cap to grow than large caps. Compare Taste holdings with Famous Brands for instance. Taste holdings only have 242 restaurants. Famous Brands in turn has 1861 restaurants. It’s much easier doubling from 242 to 484 than 1861 to 3722 restaurants. All a small cap needs is one reasonable acquisition and it doubles its revenue and profits. A large cap would need considerably more effort to do this! And remember quicker growth means quicker gains and more money in your pocket!

•    Small caps benefit because they have nimble operations

The larger a company becomes, the more difficult it is to manage. Smaller companies often find themselves in growing industries and are able to respond to changing market conditions. Large caps have less success adapting because they become deeply entrenched in a specific role. At the same time, smaller companies are often run by dedicated founders or a small management team that is dedicated to increasing shareholder value.

•    Small Caps offer greater value opportunities

Small-cap stocks are rarely covered by large brokerage firms or investment funds. This means there are fewer people in the loop of what’s going on at these companies. Hence there are often times in which a company is growing rapidly while most of the market is unaware of it…

Generally, these factors reduce the number of buyers for a stock, often causing prices to be unjustifiably low. As these companies grow and perform, the stocks gain more attention, increasing volume and valuation.

•    Small caps can take on calculated risks easier

Because small caps are smaller, with fewer employees and lower expenses these companies are more nimble. They can take risks far easier, and thereby pursue new growth trends and react to opportunities quicker. This also helps with higher growth. This advantage is critical to long-term success. Capitec bank is a great example of this, the bank saw the opportunity to enter the low income market segment before big banks could and that’s now proven to be the big differentiator for this company!

What you need to remember when investing in small companies

While allocating a portion of your portfolio to small caps can increase reward without raising overall risk, it's still important to understand that small caps carry a unique form of risk worth considering. Heed this risk and you could make handsome returns, ignore it at your own peril:

•    The most important risk to remember with penny stocks – Low liquidity

As I mentioned, penny stocks or small caps aren’t covered by the mainstream analysts and media. And because of this they go unnoticed by much of the market. This means that shares trade less frequently because there are less buyers and sellers. This means at times, there may not be enough buyers or sellers to fulfil a particular order.

The obvious risk here that you could get caught in a position where you want to sell your shares, but can’t because there aren't enough buyers in the market. For this reason, you should never invest too much in one small-cap stock to ensure your orders can be fulfilled. As a rule of thumb I say not more than 10-25% of a shares average daily trade liquidity – especially when you are a novice.

An additional risk with low liquidity is increased bid-ask spreads. This is the difference between what sellers ask for their shares and buyers offer. To avoid overpaying for a small cap you should try sticking to limit orders when buying.

•    Less Information means less certainty

As I mentioned earlier, analyst coverage on small-cap stocks is extremely limited. While this can ultimately be a benefit for investors putting in their due diligence, it can also create problems for you. The fact is, with less information and research available on shares it’s more difficult to make an informed decision.

So, unlike with large companies where you can quickly download more than one research report on the company with penny shares you will need to do your own in-depth research or make sure you're listening to someone else who has done his own. By knowing more than the next guy, you can turn the environment of limited information to your advantage.

Remember these things and start investing profitably

Smaller shares are more profitable than the rest of the market on average. It’s been proven over years and years.

But the fact remains, to make money on the stock market you need to manage your risk. Get the highest returns possible while sticking to acceptable levels of risk.

So, keep in mind the benefits of small companies. They are nimble, they can grow easier and even the smallest of deals can have huge consequences to the upside.

Just remember to watch liquidity, limit your position sizes to limit your potential losses and do proper research. Then you are well on your way to investing profitably on the JSEs most lucrative market, Small Caps…

I help my Red Hot Penny Shares readers do this successfully every year. So far, we’ve made a small fortune from these small cap shares. If you want to share in the profits, then click here.

Here’s to unleashing real value,
 

Francois Joubert
Red Hot Penny Shares Editor,
RedHotPennyShares.co.za


The ‘must know facts' about penny share investing
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