The world of penny stocks can be exceptionally alluring to investors. Watching a business’s share price explode by triple, or even quadruple, digits in a matter of months can lead to a substantial fear of missing out. Of course, this emotional trap probably ranks as one of the top catalysts to making poor investment decisions. But is there a way for me to filter out the duds?
Over my near-decade of investing experience, I’ve spotted two common traits that could indicate a stock price is on the verge of collapse.
Penny stock trap #1: undiversified revenue stream
As with any business, a better-than-expected earnings report is often a driver for explosive growth. This effect is only amplified as the market capitalisation gets smaller. Typically, securing new customers or contracts can be responsible for impressive returns. But while most investors are too busy getting excited by the hype, I sit back and ask a simple question – where is the money coming from?
All too often people focus on whether or not the top line is expanding and then end their enquiry there. But just because revenue is climbing doesn’t mean it’s sustainable. Take Novacyt as an example.
This young medical diagnostics firms hit the motherload when the pandemic reared its ugly head. By being the first company to produce a Covid-19 rapid testing kit, its revenues jumped 900%. Unsurprisingly, the share price followed suit, and the stock was up nearly 3,000% within nine months!
But for anyone who invested at that peak, their position currently has a -75% loss because the penny stock has since collapsed. As impressive as the surging revenue was, the vast majority came from a single contract with a single customer that later terminated its relationship. Since then, Novacyt has made good progress in slowly replacing lost income with new clients. And over the long-term, it may even return to its short-lived glory. But that may be little comfort to those nursing big paper losses on the shares.
Penny stock trap #2: the one-trick pony
Beyond needing a diversified client list, I look for businesses with multiple sources of income. Why? Well, suppose a penny stock’s current or future revenue depends on a single project. In that case, all it takes is for that project to fail, and the company could collapse. Investors of Helium One Global know this all to well.
This young mining group operating out of Tanzania focused on extracting helium. With demand for the element rising from the medical and aerospace industries, investor hype was on the rise after the firm announced it may have found up to 138 billion cubic feet of the stuff.
Between March and August earlier this year, the penny stock surged over 300%, only to collapse by the end of the month. Once again, late investors suffered a giant red mark in their portfolio.
What happened? This serves as a perfect example of a single-asset risk. Despite releasing promising early data, the firm discovered that the gas was of poor quality when drilling began. And, consequently, this flagship project became unviable. That’s understandably disappointing, but there remains a chance of a potential comeback. The group did discover reservoir potential in an unexplored region that may allow Helium One to continue its mission to become a global helium supplier over the long term.
Zaven Boyrazian has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
