A penny stock typically refers to the stock of a small company that trades for less than R10 a share. Some penny stocks trade on large exchanges like the JSE, NYSE or FTSE. But some of them trade over the counter, or through alternative exchanges like the Cape Town Stock Exchange or A2X.

In the US the Securities and Exchange Commission (SEC) defines a penny stock as any share trading below five dollars.

New and experienced investors alike can sometimes be drawn to them merely by their very low prices. But before you jump into the penny stock world, it’s important to learn the basics of these low-priced stocks and their pitfalls.

-Discover the best penny share research right here –

What are the characteristics of penny stocks?

Penny stocks are unique for several reasons. Understanding these characteristics can help investors make informed decisions.

These are small companies with low priced shares. The low prices however don’t necessarily mean the stocks are cheap. Rather they could reflect that there’s a lack of liquidity available due to not enough shares changing hands on the stock market.

This lack of liquidity is typically because these companies are so small they simply don’t register on the radars of big fund managers – who focus on investing in companies that have billions in capital.

Penny stocks are infamous for their volatility. Prices can skyrocket or plummet in a matter of hours. The potential for high returns often lures investors, but it’s important to understand the risks associated with these high rewards.

How to spot a Penny stock with potential?

So, how do you go about identifying which penny stocks are the winners from the plethora of options available to you? The following tips can help:

• Study the fundamentals The best way to identify the potential of a company is by studying its fundamentals. Fundamental analysis, in particular, can be very useful. Look at key ratios like the price-to-earnings ratio, debt-equity ratio, dividend payout ratio and other such metrics.

• Check the company’s valuation Valuation can tell you crucial details about the company. If a stock is overvalued, it may not be a suitable investment because of potential price drops in the future. On the other hand, an undervalued penny stock may hold some potential for price rise over the long term.

• Beware the dilution Effect Stock dilution occurs when a company issues more shares, thus reducing the ownership percentage of existing shareholders. If the penny stock you hold suffers from the dilution effect, the overall value of your holdings could further reduce.

How to invest in penny stocks (if you’re up to doing it)

If you want to take advantage of the opportunity these small companies offer, you certainly have to take some precautions as well:

Determine the maximum amount you’re willing to lose. Figure out how much money you can afford to lose and then limit yourself to investing that amount. If your investment goes under as some penny stocks do – then you won’t be in real financial trouble.

Get a second opinion. Be sure to conduct independent research on the penny stock companies that interest you. Too often, investors rely solely on information from the company itself or from stock promoters, leaving them prey to fraudulent schemes. If you can’t find any information from third-party sources, that by itself is a warning sign that a pump-and-dump scheme may be occurring.

Determine the maximum price you’re willing to pay. Due to relatively low trading volume, penny stocks can have substantial bid-ask spreads. If the ask price is significantly more than you’re willing to pay, don’t rush to meet it. Penny stocks tend to be highly volatile, and there’s a fair chance that your bid will be met if you are patient.

Be realistic with your expectations. Finally, you won’t become a millionaire overnight. That said – these shares can generate big moves in short time periods. Up or down. So, you need to be ready for the ride.

My favourite dividend paying penny stocks right now

Dividend penny stock #1 – a highly speculative dividend stock with huge upside potential

Octodec is a property company with property in the Pretoria and Johannesburg CBDs. The company owns properties that are older, and more difficult to manage. But it has done so very effectively for decades now, and hasn’t missed a single dividend since 1992!

Before the Covid lockdowns the company paid a full-year dividend of R2 a share, with a share price of R17.

Today its share price is around the R9 level. The company is however on the recovery path – and dividends are around the R1.40 per share level. That means you get a dividend worth around 15% of the current share price!

Dividend penny stock #2 – An old world business, with new world profits

Caxton’s most recent results put the company’s annual profit at 188.6cps, strong enough to put the stock on a PE ratio of only 5.78.

Perhaps more important – the company’s net asset value is R20.22 – DOUBLE its share price.

The company also just declared a 60cps dividend – putting it on a 5.5% dividend yield.

To find out more about opportunities like these in the exciting world of penny stocks – click here to find out how to claim a free copy of my top Penny Shares to buy now.

PS. Not ready to find these opportunities on your own? Then let me help you.

Not a subscriber to Money Morning?
You can get free daily recommendations like these with Money Morning eletter. Just sign up here.