Investing in ASX penny stocks

Penny stocks can be popular with investors willing to take on extra risk for potential additional rewards. Here we look at the pros and cons of investing in ASX shares from the small end of town.

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What are ASX penny stocks? 

Penny stocks are shares that typically trade for less than $1. Sometimes they swap hands for a few cents only – hence the name. They are typically young, micro-cap shares and more volatile than larger, more established shares. This can mean more significant variations in the share price. 

These micro-cap stocks can seem like a bargain – after all, some ASX shares trade for hundreds of dollars! But whether a stock is a bargain depends less on its share price and more on how the share price compares to the company's future performance. 

Although the low cost of penny stocks can lead investors to believe they have the potential for exponential growth, trading them can be risky, with a high potential for loss and even fraud. 

Why invest in them? 

Stock trading or share dealing in young companies with low valuations or depressed stock prices can achieve strong returns. Unfortunately, it can also be a way to rack up significant losses. 

Just because a stock is trading cheaply does not mean it is a bargain. The actual share price of a stock is far less important than its potential to generate significant profits or growth. 

That said, there are many good reasons to buy into small caps. Investors in small, fast-growing companies can capture substantial gains compared to later investors who wait until those companies have grown. 

The key is to research and understand the path a small company will take to profitability, keeping in mind that there may be unexpected hurdles along the way. 

What to look for when buying micro-cap shares

Successful investors in penny shares tend to pay little attention to the actual share price. They focus on the relevant company's potential to grow and generate revenue. They look for a solid investment case that will remain strong despite likely future volatility in the share price. This might be a new technology, a new way of doing things, or even some sort of exclusive right capable of exploitation by the company. 

Because Australian shares that classify as penny stocks tend to be small companies in the early stages of business, they may not be generating revenue yet. 

If this is the case, a plan must be in place to generate and grow revenue. This is crucial as all listed companies must come to profitability at some stage if they are to provide shareholder value. 

Top penny shares on the ASX

(Based on market capitalisation from high to low.) 

Brainchip Holdings Ltd

The company behind the world's first commercial neuromorphic processor,

which mimics the human brain to process data with efficiency and precision
Bubs Australia Ltd

Leading producer of goat dairy products in Australia, including the only

infant formula in the world based wholly on Australian goat milk
Carbon Revolution Ltd

Produces lightweight carbon fibre wheels for the automotive industry that

are used by Ford and Ferrari, among others 

Brainchip Holdings 

Brainchip is the company behind the Akida, the world's first commercial neuromorphic processor. The Akida mimics the human brain to process data with efficiency, precision, and economy of energy. 

It provides enhanced security by locally processing, storing, and analysing sensitive data. The Akida can lower data centre workloads, decrease power consumption, and increase efficiency by shifting tasks and functions. 

Bubs Australia

A leading producer of goat dairy products in Australia, Bubs makes a range of premium infant nutrition and wellbeing products. The company produces the only infant formula in the world based wholly on Australian goat milk. 

Other products include goat milk-based formulae for adult use, and specialist formulations. Bubs products are widely sold in major supermarkets and pharmacies throughout Australia and exported to China, Vietnam, South East Asia, and the Middle East.

Carbon Revolution 

This company supplies lightweight carbon fibre wheels to the global automotive industry. Its wheels are 50% lighter than aluminium wheels but have the same strength. Carbon Revolution was founded to bring disruptive efficiency technology to all vehicles but has initially penetrated the performance and premium end of the market. 

More than 50,000 Carbon Revolution wheels are now on the road thanks to partnerships with Ford Motor Company, Ferrari NV, General Motors Company, and Renault SA

Benefits of investing in ASX penny shares 

Investing in penny shares entails significant risk, but when they turn out well, they can be seriously lucrative. Many blue-chip shares on the ASX today started life as micro-cap stocks. For example, Altium Limited (ASX: ALU) was a penny stock less than a decade ago and now has a market capitalisation of $4.9 billion. 

Buying early into a successful penny stock can provide significant financial benefits, provided investors continue to hold the shares as they grow in value. 

It is also vital that other investors are willing to hold their shares, as it takes relatively few sellers to undermine confidence in a penny stock, which may then adversely impact its price.  

Penny shares tend to be smaller companies, which comes with some advantages. It is easier for a small company to grow quickly. Larger companies eventually reach a growth rate ceiling. Penny stocks also offer ASX investors the opportunity to purchase large quantities of shares for relatively little outlay. 

This means ASX investors can afford to invest across a range of penny stocks in different market sectors while balancing these high-risk investments in the context of a broader portfolio. 

What are the risks?

Penny stocks are often cheaply priced for a reason. They may be unproven, or their prospects for long-term success are mixed. In the worst-case scenario, they may be vehicles utilised by con artists to trick unsuspecting investors. 

Investors in penny stocks often believe a low stock price means greater potential for share price growth than shares with higher prices. This is erroneous. Market capitalisation is determined not just by the share price but the number of shares outstanding. 

For example, a company worth $100 million could issue a million shares at $100 each or 100 million shares at $1 each. It is entirely up to the company. 

Penny stocks tend to entail more risk than higher-priced shares. This is because: 

  • The companies behind penny stocks are usually small and have not yet proven they can endure and succeed 
  • Penny stocks can, at times, be the target of pump-and-dump schemes. These occur when cons invest in a penny stock and then hype it as the next hot investment. This hype can cause the stock price to rise, at which point the con sells their stocks for a profit and ceases promoting the company. The share price then takes a tumble, leaving later investors with significant losses   
  • Penny stocks are often thinly traded. This means there are fewer buyers and sellers in the market for them. So, there may not be enough buyer demand when an investor in a penny stock seeks to sell. 

Buying penny stocks can appear to be an easy way of growing your money quickly. But penny stocks have a reputation for being speculative, and for good reason. 

Are ASX penny shares a good investment? 

Any ASX stock can be risky, but the risk associated with ASX penny stocks is even higher. They have significant upside growth potential but lack the stability of larger, more established stocks. Any investor in micro-cap or small-cap shares needs to be prepared for the possibility of losing all their money. 

For this reason, investing in penny stocks tends to suit those comfortable taking on higher levels of risk. They may not be suitable for risk-averse investors. 

Ultimately, whether ASX penny stocks are for you will depend on your financial situation and investment objectives. Any stock market investing entails an element of risk, which should be considered in the investment decision.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

Motley Fool contributor Katherine O'Brien has positions in Altium. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Altium, Atomos, and Carbon Revolution. The Motley Fool Australia has recommended Bubs Australia. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.