Penny stocks – those costing less than £5 or $5 – can be bargains if you choose wisely. But watch out for fraudulent scams trying to manipulate the market.

We’ve all probably had those spam emails promising ‘awesome’ returns on a hot new biotech company that has developed a cure for cancer and whose stock is about to go through the roof.

Penny stocks can make big gains – and big losses

Hopefully we’ve consigned those to our junk folders where they belong – someone is trying to make a fast buck by illegally manipulating the market, and you would be the fall guy.

But that doesn’t mean there aren’t really bargains out there in the penny stocks market – though you need to do your research carefully, or you could get your fingers badly burned.

What is a penny stock?

So just what is a penny stock? First of all, they don’t literally cost a penny, although you can find some for under 10p per share. The definition now loosely covers shares trading for less than £5 in one of the smaller markets such as the UK’s FTSE SmallCap or the AIM All-Share indices. In the US, the term refers more specifically to stocks worth less than $5 trading with the OTC Markets Group or FINRA’s OTC Bulletin Board.

There are certainly bargains to be had – the FTSE SmallCap index, featuring smaller capitalisation companies on the London Stock Exchange (LSE) main market, rose 43.7% in the five-year period ending April 26, 2017. Stocks range from household names such as Moss Bros and Mothercare to small-scale tech and pharmaceutical companies.

Meanwhile the LSE’s AIM market, launched in 1995, lists more than 3,500 businesses from around the world, including early-stage and venture-capital enterprises, as well as more established companies. The FTSE AIM All-Share index rose 19.2% in the five-year period ending April 26, 2017.

Huge gains

If you’re keen to take advantage of the huge gains that can be made in the tech and pharma markets thanks to the rapidly changing pace of technology, then there are certainly opportunities to make big gains out there. One only has to think of names such as Facebook and Twitter to see the potential, if you can catch them early.

The growing trend for management buy-outs (MBOs) can also offer good pickings, as the management team will have put their own cash on the line to buy the company they have been working in, so the fundamentals should be sound.

But for every big name that has made investors rich, there are others that have failed. These small, fast-paced stocks can crash and burn just as quickly as they rise, so it’s very much a case of buyer beware – and never invest more than you can afford to lose. They are not something to put into your pension portfolio.

There are many more penny stocks in the US markets – more than 15,000 at the last count – and many more chances to come a cropper.

Checks

Whether you are looking at stocks in the UK or US, never buy on a whim – it’s essential to carry out thorough research. Here are some basics checks to carry out:

• Fake news: Be very careful not to be taken in by fake research in the shape of newsletters or websites praising the merits of certain stocks – they can be a lot more deceptive than those spam emails. Check for a disclaimer at the end of any articles as to whether there is any financial incentive has been given to the writer for promoting named stocks.
• Real news: Search the company to see if it features on financial websites – whether for good or bad.
• Financials: The LSE (www.londonstockexchange.com) offers an in-depth company profile for every stock it lists, including news updates on changes in shareholdings and trading updates. It also gives a detailed balance-sheet breakdown, offering information not just on revenue and profits, but also details such as earnings per share, a breakdown of assets and liabilities, share capital and reserves. The LSE also offers free FTSE Analytics reports on companies, with graphs showing the performance of stocks relative to the sector and the index, and a wide range of valuation metrics.
• Directors: You can find out the names free of charge via the Companies House website at www.gov.uk/get-information-about-a-company – then make a web search and see what comes up. You should be looking for their past background, together with any other directorships or major financial involvements. Are they known names – have they had any notable successes or failures, either as senior management or directors of other companies? Try to carry out background checks on CEOs/CFOs, too – they should be named on the company’s own website.

Buying and selling penny stocks

You can buy penny stocks through online brokers for a minimal charge – shop around for the best deal.

Buy with your head, not your heart – you may think a stock has amazing prospects, but is it being hyped? Don’t get carried away by positive news stories, and be careful how much you invest. Don’t invest more than 2% of your overall portfolio, and your penny stock investments as a whole should never make up more than 10% of your portfolio.

Once you’ve bought, you need to be ready to sell. Penny stocks are not a long-term banker. When you think they’ve done all the rising they are going to do, cash out and move on. The aim is to sell just before they hit the top of the curve.