I'm going to be brutally honest and say that the Australian share market is filled with many utterly terrible small companies.
Therefore, you need to know what you are doing if you plan to fish at the bottom of the barrel.
Penny stocks
At the bottom of the ASX, you will not find quality Australian businesses like Commonwealth Bank of Australia (ASX: CBA) or Wesfarmers Ltd (ASX: WES).
Even when they first came to the ASX many moons ago they weren't penny stocks.
By "penny stock" I mean companies with a market capitalisation — the value of all shares in the company — under $50 million.
"It's only a little bit of money"
That's what most people say when I begin to explain how bad penny stocks can be. But did you know that $1,000 reinvested at 8% over 25 years is almost $7,000?
Note: the sharemarket has returned more than 8%, on average, over the long run.
If you added $10 per week to your investment it would become almost $45,000.
But, sure, here's a lighter — let's just set fire to your 'little bit of money' now.
Why penny stocks — on average — are crap investments
If you think about it, if all shares in a company are worth less than $50 million they must be either tiny companies, unprofitable or terrible because:
- If you were the owner of a successful small business, would you sell your shares to other investors on the sharemarket? No!
- If a good company has profit over $2 million, would all of its shares be worth less than $50 million? No, because that would mean it has a price-earnings ratio (P/E) of 25x. Most 'good' small companies have a much higher valuation than that.
- At best, there is very little oversight from investors. Most penny stocks are not owned by professional investors who can keep an eye on management.
- At worst, the regulatory overnight is almost not existent. Last year, I pointed out that JC International Group Limited (ASX: JCI) was a 'curious' investment (I'm being generous), while shares of Henry Morgan Ltd (ASX: HML) have been suspended since the beginning of June!
Know what you are doing
Buying penny stocks can be disastrous if you do not know what you are doing.
You: "How do I know if I'm doing it right?"
If you can answer these questions, I reckon you have the tools to know what you are doing:
- Honestly, can you turn over 20 companies and still have the emotional stamina to not buy one of them? That's important because 95% of them could be garbage.
- Can you build a DCF from the ground up? (Note: if you don't know what a DCF is — you cannot build one)
- Can you diversify? Meaning, do you have enough capital to hold up to 20 of these companies without using a loan?
Basically, you need to be committed to investing and developing your skills.
In the five years I have worked in the finance industry I have met only two people who have invested in penny stocks successfully. And it is their life's work.
If you're not prepared to make it yours, I advise you to avoid penny stocks altogether and buy shares of quality dividend-paying small, medium and large cap shares.
