If you've been a reader of The Motley Fool for any amount of time, you are probably familiar with our stance on "penny stocks" -- just say no. I hasten to add that it is with good reason that we urge investors to stay away from the pennies -- and I encourage you to read the articles in the "related links" section of this page for more about the dangers of penny stocks.

What is a penny stock?
But what exactly are penny stocks? As has been loosely defined by various writers here at The Motley Fool, they are companies with share prices of below $5 and market caps below $200 million.

While I agree that when combined, avoiding stocks with the two criteria above will dramatically lower your chances of getting sucked into a penny stock scam, personally, some of my best ideas would have qualified as a "penny stocks" -- i.e., the stock was trading at less than $5 and had a market cap of less than $200 million when I purchased my shares.

While I strongly believe that beginning investors or those without the time to do in-depth research are much better off sticking to bigger fish, I just as strongly believe that for advanced investors, with the time and the inclination, finding the undervalued gems with market caps of between $50 to $250 million offers the best chance to beat the market -- and some of them will happen to trade for less than $5 a stub. I think that, if you know what to look for (and what to look out for) going in, an advanced investor can do a lot to separate the gems from the scams in this area of the market.

But before I tell you what I look for, you're going to get some disclaimers (you didn't think I'd just let you go on to the good stuff without scaring the pants off of you first, did ya?)

Who should target small stocks?
It is my true conviction that those with less than one year's experience investing in individual stocks should not even think about investing in small cap stocks, particularly if you haven't found your rhythm with the mid- and large-cap universe yet. Also, until you know your way around a balance sheet, income statement, and cash flow statement like you know the route from your house to the nearest convenience store, don't even think about it.

Finally, you need to be suitably prepared to take everything you hear and read with a grain of salt, be ready to challenge every assumption, and in short, examine every possible scenario that could cause your company to fail in order to ensure that you are getting a real business for your money. Also, you need to have the time and the desire to keep digging for more information, even after you've bought the stock, so that you know more about it than your average Fool small-cap writer.

Even armed with the disclaimers above, it's best to concentrate your efforts where it will bear the most fruit -- and that means knowing where not to go.

Where not to go
First of all, I don't bother with stocks that aren't traded on one of the major U.S. exchanges. That means no bulletin board (better known as over-the-counter, or OTC) stocks for me. Essentially, most bulletin board stocks are those that for whatever reason don't qualify (or can't afford) a listing on one of the major exchanges. Besides, my online broker doesn't offer bulletin board stocks, so I couldn't buy one if I wanted to. So I just don't bother.

Second, if the company doesn't have revenues, I look no further. And if the revenues aren't at a minimal level, say, $10 million annually or so, it isn't worth my time. I also make sure that the company has been generating revenues for several years -- I don't want any flash-in-the-pan companies in my portfolio. I typically am exceptionally careful in the sub-$50 million market cap area -- and I generally don't go in there unless the situation is almost perfect. 

Third, I never, ever waste my time looking at those small-cap companies that are hyped in the various e-mails I get from websites and promoters that are dedicated to penny stock investing. Just about all of these promotions are paid advertisements in which the company gives the penny stock tip-sheet operator some sort of payment, either in shares or in cash, in order to hype the stock. I just delete those messages.

Finally, I don't bother looking at companies that compete in industries that I don't like or understand well. I know a couple of industries pretty well, and I know of several industries where the economic characteristics are outstanding -- and I stick to those.

As a final disclaimer, I never, ever invest in any small company without having first read its annual 10-K and most recent 10-Q filing. I never fail to find some piece of material information (either good or bad) that changes the way I think about the investment as a result of reading these two documents.

What I look for: cash, cash, and more cash
Essentially, when evaluating small companies for investment, the ability to generate cash is king. I look for companies that have demonstrated the ability to consistently generate cash, and are actually growing their free cash flow over time. I aim to buy these companies at a very low multiple on that cash flow -- ideally under six times. This low price compensates me for the risk I am taking by purchasing a tiny, illiquid stock -- it's the old "margin of safety" that I am looking for.  I never try to pay fair value for these stocks -- if I don't think I am getting the company for 20 or 30 cents on the dollar, it's not worth the risk.

The other thing I look for is cash on the balance sheet. If I find a stock trading for $3 a share, and that company has $2.75 a share in cash on the books and is also generating cash from the business, well... it's tough to lose a lot of money on those types of stocks.

As a final risk-control technique, I limit any tiny stock to no more than 5% of my portfolio, and usually I keep the percentage to 2.5%. That way, even if I'm wrong, I haven't invested more than I can afford to lose on any one stock.

Zeke Ashton urges extreme caution even for advanced investors who are considering looking at tiny companies, and is not responsible for you losing your shirt to some penny-stock-pumping scam artist if you do. The Motley Fool has a full disclosure policy.