Penny Stocks From Heaven

If you're reading that headline and scratching your head, I don't blame you. "What? The Motley Fool? Advocating penny stocks? It isn't April 1st, is it? Have I gone mad?" -- all of these questions may be running through your head. I can't speak to that last point, but no, this isn't a misprint. Bill Mann's scathing critique of penny stock huckster Chris Lahiji is as true today as it ever was. Rex Moore's excellent overview of how to find small caps uses a screen that looks at firms only trading for more than $7 per share.

There's a darn good reason for all this, folks: Hucksters abound in penny-stock land (normally defined as sub-$300 million companies whose stock trades at less than $5 per share). These thinly traded firms can see huge gains or losses because of news, rumor, and innuendo. I've no interest in fanning the flames of day traders or crooks seeking to rip off legitimate investors.

That said, it often pays to be contrarian over the long haul in investing. And so it is in that spirit that I say to you, dear Fool, that not all penny stocks are created equal. Some are fiscally sound companies whose share prices have been wounded by unfortunate events, and some are just undiscovered. Either way, there's money to be had.

Speculating isn't gambling
In one of my all-time favorite investing books, The Intelligent Investor, Benjamin Graham lays out the principle of informed speculation -- that is, betting on a stock whose valuation is anything but certain but where enough circumstantial evidence points to a gain. Maybe even a big gain.

Graham puts it this way: "...it was the speculator who looked out and saw future developments before other people did. But today, if an investor is shrewd or well-advised, he too must have his lookout on the future...where he rubs elbows with the speculator." Well-said, Ben. The point, of course, is that speculating is gambling only when it isn't well-informed. I've come to call it taking an unjustified intellectual risk.

Cheaply priced stocks aren't simply supposed to go up because they're cheap. And "cheap" is a relative term anyway. Yes, Sirius Satellite Radio (Nasdaq: SIRI  ) might be a Rule Breaker. But even the $3.92 per share it commands as of this writing puts the stock trading for more than 150 times sales. If you're thinking that's outrageously expensive by classic valuation standards, you're right.

Some cheap stocks will always remain cheap. Others will just go away. Firms such as Akamai (Nasdaq: AKAM  ) and Bankrate (Nasdaq: RATE  ) that came back from penny-stock land to generate massive returns for investors are in the distinct minority. Finding them is still an exercise in Foolish fundamental stock analysis.

Some gems aren't just hidden, they're tiny
For years, we here at the Fool have advocated screening for small-cap gems through what's become known as the Foolish 8 criteria. Besides calling for strong margins, cash flow, and earnings growth, the Foolish 8 also set a per-share minimum price of $7. While the screen has performed remarkably through the years, it isn't perfect. (Indeed, Rex Moore recently improved it. You can get access to the new screen by taking a free, 30-day trial of Motley Fool Hidden Gems.)

In fact, I'd say the per-share minimum is an investing rule that's just begging to be broken given the right circumstances. Hidden Gems lead analyst and Fool co-founder Tom Gardner agrees, believe it or not. In July, subscribers were treated to a new subservice called Tiny Gems, where otherwise good stocks that normally don't meet the capitalization or per-share minimums are profiled. They aren't formal recommendations but nonetheless demonstrate that some good companies trade for dirt-cheap. For example, take a look at the numbers for RF Industries (Nasdaq: RFIL  ) , an inaugural star of the Tiny Gems stage trading for a total enterprise value of $14 million as of this writing:

Metric TTM 2003 2002
Sales $11.0 $9.9 $8.9
Earnings $1.2 $0.7 $0.4
Structural free cash flow $1.2 $0.8 $0.6
Gross margin 48.9% 48.6% 47.6%
Net margin 10.42% 7.19% 4.26%
Return on equity 13.12% 8.06% 4.04%
Data provided by Morningstar. All numbers except percentages are in millions.

Notice the steadily improving financials. It's also notable that the firm has $4.5 million in cash and zero debt as of the last reported quarter. Only firms built on such a solid foundation, or whose market potential is extraordinary, deserve your attention when sorting through cheap stocks.

The Peter Lynch principle
Remarkably, some of the world's best investors -- champions of fundamental analysis who eschew day trading -- have more than dabbled in penny stocks. Perhaps none are more famous, or more respected, than Peter Lynch.

Not long ago a Fool on our discussion boards revealed that Mr. Lynch's filings with the Securities and Exchange Commission showed a pattern of bets on thinly traded, ultracheap stocks. In a sense, it profiled Mr. Lynch as the ultimate rule breaker: willing to swing for the fences for a chance at massive returns, even if a few of the bets are caught for outs.

Mr. Lynch's list from that enlightening post is a virtual tour of penny-stock heaven. Varsity Group (Nasdaq: VSTY  ) has to be considered the pick of the litter. Picked up by Lynch in 2001 for somewhere near $0.30 per share, the firm trades for $6.20 per stub as of this writing. That's north of a 20-bagger, folks.

Ask an expert
Of course, Mr. Lynch is an expert. He's a legendary investor whose research and approach brought investors in the FidelityMagellan (FMAGX) fund annualized returns of 29%. Fortunately, we're privy to his expertise when it comes to penny stocks, because the government lets us know what he's investing in. Indeed, you can check the portfolios of any of the masters. All you need do is search under their name at the SEC's Edgar database.

You know where I'm going with this, right? Of course you do. When it comes to seeking penny stocks, your best starting place just might be to see what the masters are investing in. It isn't hard to find out. Going back to Edgar, a search of "Lynch" brings up 73 filers. Scroll halfway down the page...yep, right there...and you'll see the entry for Peter S. Lynch. Now, take a look. He's got 56 filings on record; the last, from March, shows he owns 67,500 shares of WorldQuest Networks (Nasdaq: WQNI  ) , trading at $2.35 per share as of this writing. WorldQuest sells prepaid calling cards and routes calls over its Voice over Internet Protocol (VoIP) network.

The truth is you can do this same exercise with any money manager you like. Even superinvestor Warren Buffett files with the SEC, as does my personal favorite, Mario Gabelli.

Investigate, then diversify
What's most instructive about Mr. Lynch's list of penny stock holdings is how many there are. His filings show he owns, or has owned, at least 15 penny stocks in recent history, likely most at the same time. Since we've argued here over the merits of broad diversification, you might think Mr. Lynch slightly nuts for loading up on so many high-risk securities. Yet you'd be missing the point of his approach in doing so.

Mr. Lynch is practicing a strategy that I think every Rule Breaker investor should. He's selecting a diverse set of high-risk, high-reward stocks for a portion of his portfolio, betting that if he strikes out several times, the one or two home runs he hits will be a grand slam, such as Varsity Group. Indeed, that's the way it's worked for Fool co-founder and Motley Fool Rule Breakers chief analyst David Gardner. Sure, he's bet and lost (so far) on Krispy Kreme (NYSE: KKD  ) , but he's bet big and won on Amazon (Nasdaq: AMZN  ) and Starbucks (Nasdaq: SBUX  ) . In each case he had an investing thesis grounded in thorough analysis, even if the companies at the time were anything but proven.

The Foolish bottom line here is simple: Every penny stock trades lower for a reason. If you bet on one, you'd better know why it's so unloved and have a good reason to believe the general sentiment is wrong. This isn't Vegas, folks. Much as it might seem like it at times, the stock market doesn't sell lottery tickets.

Fool contributorTim Beyersis one-part gem hunter, one-part rule breaker. He owns no penny stocks, but he wishes he had bought Akamai, in which he owns shares, as a penny stock. You can view Tim's Fool profile and stock holdingshere. The Motley Fool has adisclosure policy.


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