Definition of What I Call ‘Good Penny Stocks’

In order to find solid penny stock picks, you should ask yourself and define what you call a “good” or “bad” penny stock. In investing, what you should do is always protecting your capital. Considering that micro-cap companies are more volatile and speculative than big-cap market leaders, it is important to get a solid definition of an outstanding  penny stock and of course look and invest in those companies.

In summary, we think that a “good penny stock” should have the following characteristics:

1) Above average earnings yield:  higher than 7%

Earnings Yield is measuerd by calculating the ratio of pre-tax operating earnings (EBIT) to enterprise value (market value of equity + net interest bearing debt). The basic idea behind the concept of earnings yield is simply to figure out how much a business earns relative to the purchase price of the business.

Joel Greenblatt, author of ¨The Little Book That Beats The Market¨ likes companies with high earnings yields and solid business models. In other words, the fact that a good company trades at a high earnings yield may represent an undervalued opportunity. You should always look for micro-cap companies with sustainable prospects and high earnings yield.

2) Above averge returns on invested capital (ROIC): higher than 25%

Return on capital is measured by calculating the ratio of pre-tax operating earnings (EBIT) to tangible capital employed (Net Working Capital + Net Fixed Assets). By calculating the ROIC, you can understand how much capital a business has to commit in order to generate returns.
You should aim for businesses with light capital expenditures because that translates into higher margins and net profits.

If your goal is to find solid penny stocks to invest for the long term, you should pay attention to a company’s ROIC. The ROIC measure gives a sense of how well a company is using its resources to generate profits. You should aim for consistency here because a one-time item could translate into a high (but short term oriented) Return on Capital Employed.

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3) History of solid profitability: more than 3 years of solid profitability

In order to get a good company you do not want just one or two quarters of solid profitability. You should aim for companies with a strong record of both top and bottom line growth. There are many companies with market capitalizations below $50M that have been experiencing earnings growth year over year.

Remember that you are investing for the long term and a company with a volatile earnings profile could add problems to your portfolio.

4) Strong management team: aligned interest with shareholders

Management is key when investing for the long term. We have a strict rule when analyzing management teams: we want management teams that own a sizable portion of the company´s outstanding shares. By that way we are sure that management is aligned with our interests.

One of Warren Buffett´s main skills is analyzing management teams. He looks for management that are fairly compensated and buy backs a lot of the company´s shares. Executive compensation is a very important item to analyze here: you do not want managers that make a huge amount of money while the stock goes down. If a manager really cares about the shareholders in the long term, the manager should lower its compensation when the economy or business conditions are tough.

5) Decent balance sheet: Zero debt and high current assets

We like penny or micro-cap companies with almost zero debt and high current assets. These are good picks. A company that is overly leveraged suffers in hard times and its management has fewer resources to expand the business.

Look for companies with outstanding balance sheets, that generate high amounts of free cash flow with minimum interest debt requirements.

6) Durable competitive position

This is what Warren Buffett calls a ¨business moat¨. You should get companies with an established business that has high barriers of entry to the segment that company operates. For example, it could be a specific brand, reputation or specific knowledge that makes a company get a superior competitive position.

This item is more qualitative than quantitative and you need to evaluate many businesses in order to get the clear idea. A company with a durable competitive position is the one that you are sure that its market share won´t be attacked in the coming 5 or 7 years.

7) Good growth prospects

This item is also highly qualitative. We look for penny stocks that have superb growth prospects in growing markets. For example, a Pizza Restaurant that is starting to expand its franchise operations or a small-cap leader in a rural city that plans to expand to other cities in the next years. Those are the type of examples of different growth prospects we look for.

In general you can find a company`s growth prospects inside the Annual Report, under the item ¨Management Discussion and Analysis¨. By looking in the past 3 quarterly earnings conference calls and the Annual Report (or 10-K) you should be able to understand the growth plans of any company you think on investing.

8) Reasonable valuation 

Valuation is the key in every investment decision. Remember that you are not buying a company for just 1 or 2 weeks. If you want to make solid profits you should look for companies that you can hold for many years , compounding profits and increasing your capital.

By valuation I refer to the concept of ¨margin of safety¨ where you buy a business for a lot less than a private buyer would finally purchase it. We like companies that trades at EV/EBITDA multiples of less than 8x and earnings yields above 7%.

By investing in stable penny stocks that trade at reasonable valuations you should expect to generate above than average returns for your portfolio.

Conclusion

Warren Buffett always says ¨price is what you pay and value is what you get¨. In order to generate outstanding profits from penny stocks there is one way: you must search for good penny stocks with durable competitive advantages, an expanding brand and a shareholder oriented management team. In addition, focus on ¨capital light¨ business models that create profits using minimum amounts of capital invested.

If you combine all of the above mentioned items with a reasonable valuation, you are close to discover a penny stock treasury!