One of the great things -- there are many -- about researching and writing up investment ideas on a regular basis is the email traffic it generates. Yes, there is spam and there will always be disgruntled readers, but there are also always people who know more than I do about any given company. And sometimes they are kind enough to share their extra knowledge.
The other type of email is the one from a struggling investor looking for help and asking for specific investment advice. I recently received an email like this from a friend of mine from my college days. He's an investor who has gambled big on penny stocks and found that it's a tough game to win. He wrote me looking for some new penny stocks that he could invest in or day trade to recoup his losses of the past ten years.
As much as I'd like to help an old friend out, I can't. Not because I'm a skinflint with my ideas, but because I don't have any penny stock ideas. It's an area I rarely invest in myself, and when I do it's because I've found what I believe to be a sound company that happens to have a penny stock price--not because I was searching for a penny stock. What I can do for my friend is try to turn him away from the dark side of penny stocks and onto a more stable long-term investing track. What follows is an open letter to Sam -- name changed to protect the innocent -- that will hopefully be the beginning of a more fruitful investing future.
Let go of the past
Sam, I realize you've had a tough experience with penny stocks and investing in general. I don't think it's because you lack the intelligence, but I do think that greed played a bit of a role. So the first thing I'm going to recommend is that you shed yourself of all the stocks you purchased primarily because they're penny stocks. I know this goes against the grain of how you've invested in the past, but I think you need to make a clean break.
Build a solid base to grow from
The next step is to fortify the base of your portfolio with investments that are much less volatile than penny stocks and provide you with a bit of income to grow on. I'm recommending that you take at least half of your money -- preferably somewhere around 75% to 80% -- and put it into stocks that will pay you dividends. Instead of buying stocks that trade for fractions of a dollar, you'll be buying companies that pay you a fraction of a dollar quarter after quarter.
So trade in that over-the-counter stock for some shares in a dividend payer like National City
You can still speculate
With some of your money, you can still do some speculating. I'd recommend you not directly dive into penny stocks, but, hey, it's your money and I understand old habits die hard.
While I don't recommend speculating in penny stocks, I do recommend doing a bit of speculating in turnaround situations. Look for companies that the market has beaten down for one reason or another. You can often find these types of investments on the 52-week-low list in the newspaper. What you're looking for is companies that have seen their shares beat up, but have businesses that generate cash -- lots of cash.
You can find out the cash generation qualities of the business by looking at the company's statement of cash flows in its most recent annual and quarterly reports. There are two caveats to add to this strategy. The first is that you'll also want to make sure that the company has a strong balance sheet. The company can have debt, but make sure it has a healthy cash balance as well, or that the cash flow that we looked at before is strong enough to cover the debt repayments. The second caveat is that the cash generation capability of the business hasn't been permanently damaged.
How about a sector many investors dare not touch: telecommunications? That sounds pretty risky, right? Not to Mathew Emmert, who has recommended Alltel
Other "risky-looking" investments include FactsetResearch Systems
Foolish final words
This may not seem like much, and it's certainly not what you asked me for. But I'm hoping you can look past that and see the benefits of a strategy where the majority of your portfolio builds consistent wealth and the remainder, so to speak, can be used as fuel for the fire. I recommend it to you without feeling any conflicts of interest, because it's how I invest myself and I've been pleased with the results.
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