Making Cents in Penny Stocks

The occasional shower of pennies from heaven might do our bank accounts some good. Alas, Fools can't say the same for penny stocks. They're often subject to manipulation and deceit, making it harder for investors to separate the few good offerings from the multitude best ignored.

Still, many investors enjoy dabbling at the low end of the stock-price spectrum. At Motley Fool CAPS, a "penny stock" is any stock trading under $10, and you'll find some of the best CAPS All-Stars regularly seeking out winning investments there. We identify them with a penny icon.

Pinching pennies
This week, we'll look at two low-priced investments the CAPS community has singled out as those with the best chances of success by bestowing four- and five-star ratings on them. We just might want to turn our umbrellas upside-down to catch them!

Company

Recent Price

CAPS Rating (out of 5)

1-Year Return

Est.
5-Year EPS Growth

Return on Capital

DragonWave (Nasdaq: DRWI  ) $3.28 **** (60%) 18% (12.8%)
Xinyuan Real Estate (NYSE: XIN  ) $1.80 **** (35%) 5% 10.3%

Source: S&P Capital IQ, Yahoo! Finance.

These companies may be low-priced, but that isn't necessarily enough to suggest they'll have an easier time recording big gains. Low-priced stocks are often low-priced for a reason. We have to check and see what their catalysts for growth might be before diving in to the shallow end of the stock pool.

Hiding in plain sight
Microwave backhaul operator DragonWave has suffered at the hands of its largest customer, Clearwire (Nasdaq: CLWR  ) , losing more than $21 million over the past year. The first two quarters of fiscal 2012 have accounted for more than two-thirds of the red ink. As Clearwire cut spending and slowed the build-out of its 4G network to preserve cash, DragonWave saw revenues plunge almost 80% in the first quarter and posted losses of nearly $10 million.

To offset the dependence upon Clearwire and separate itself from that company's survival struggle, DragonWave acquired the microwave backhaul operations of Nokia Siemens Networks, a joint venture between Nokia and Siemens (NYSE: SI  ) . The move will help Siemens and Nokia strengthen the venture's balance sheet. For DragonWave, not only should it gain more market share as a result of the acquisition, but it ought to diversify the company's geographic footprint as the JV has a large international presence, particularly in India.

The infrastructure there still needs to be built up to fully support 3G, so a turnaround to profitability may not come as quickly as management plans. And DragonWave will post nearly $1 million in charges this quarter related to the restructuring following the NSN acquisition.

With 96% of the CAPS members rating DragonWave to outperform the broad indexes, it's plausible they agree with the assessment of gigsjohn5 that it now has the pieces of the puzzle to achieve it: "Key cost effecitive technology to connect vioce, data, and video to the backbone. Believe number of catalysts coming."

Let us know in the comments section below or on the DragonWave CAPS page whether you think it can make the U-turn, then add it to your watchlist to see if it pulls it off.

A survivor
China's real estate market is experiencing a similar malaise as that felt by the U.S. three years ago, as the wheels began to come off the industry. Property prices fell for the fourth straight month in December, a worrisome trend even if they don't have a subprime mortgage debacle because a quarter of the country's economy is tied to real estate. Like here at home, the government interfered in the marketplace in an attempt to make homes more affordable, and suddenly cracks appear all across the foundation.

As a developer of large-scale, high-quality residential real estate projects, Xinyuan Real Estate is sort of a Toll Brothers of China, one targeting the growing middle class in high-growth tier 2 and tier 3 cities. But the government has tried to cool off the real estate industry, which has created a backlash that endangers Xinyuan.

It's a problem that seems to be spreading globally. Brazil has been a hotbed of housing, but the country's top builder, Gafisa (NYSE: GFA  ) , may face worsening conditions in the year ahead. Indeed, famed investor Jim Rogers has guaranteed a global financial calamity, and the effect on housing globally would surely get worse, if that's even possible.

Although CAPS members have as much faith in Xinyuan as they do in DragonWave, I don't see homebuilders -- whether here in the U.S. or anywhere else in the world -- a place I want to put my money, so I've marked it on CAPS to underperform Wall Street. Put Xinyuan Real Estate on your watchlist and let us know in the comments section below if you think housing will surprise its critics.

Make some change
From tiny valuations big profits can emerge, but economic upheaval can cause it to change on a dime and create obstacles to retirement happiness. Read the Fool's latest special free report, where we reveal the shocking can't-miss truth about your retirement -- and what you can do about it. Grab a copy today and find out everything you need to know.

Fool contributor Rich Duprey holds no position in any company mentioned. Click here to see his holdings and a short bio. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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