Investors are always on the hunt for the best penny stocks because they can post triple-digit profits in a short period of time.
But many investors are not aware of the risks that come along with looking for the best penny stocks...
While penny stocks can bring huge profits, they can also bring big losses and high volatility. That's why Money Morning experts advise that penny stocks should only represent a small percentage of any portfolio. And one stock should never account for more than 2% of your investing capital.
Money Morning Chief Investment Strategist Keith Fitz-Gerald says the key to finding the best penny stocks in 2016 is no different than finding other great investing opportunities. You need to know what to look for and have the right risk tolerance and perspective.
And more than anything, you need to know about the three most common traps to avoid when looking for the best penny stocks.
Here's what to watch out for...
How the Find the Best Penny Stocks: Avoid Noncommittal Management
Check out the penny stock's 10-K when you do your pre-investment research. A 10-K is a periodic report required by the U.S. Securities and Exchange Commission that details a company's financial performance.
Every 10-K report contains comprehensive information on a company's history, equity, shares outstanding, holdings, and subsidiaries. Fitz-Gerald typically searches for executive compensation and begins his research there.
A penny stock executive with an all-cash compensation package and no options or vesting is trap No. 1, according to Fitz-Gerald.
"It tells me that there's very little alignment," Fitz-Gerald said. "Worse, it suggests management has no faith in the company's long-term outlook and is using the corporate treasury as a slush fund to maximize his or her earnings even if the company goes up in flames. My experience suggests that there's a direct correlation between CEO pay and performance - the more they get, the worse their companies do."
How to Find the Best Penny Stocks: Dodge Suspicious Spending
It's not unusual for penny stocks to operate in the red for many years and still have an extremely promising future. Here again, a company's 10-K is an excellent point of reference.
"The 10-K can be very helpful because it shows not only a company's condition at a specific point in time, but over time," Fitz-Gerald explains. "That, in turn, will tell you whether the company is moving in a direction that's consistent with its stated goals."
Look to see if the company's spending is absolutely consistent with its objectives and not being diverted to "research," outside assets, or any other questionable avenues.
How to Find the Best Penny Stocks: Don't Pay for Hype
When is the last time you heard of a hot new stock through a phone call, an email, or brochure? These are all likely traps.
You see, promoters and unscrupulous corporate insiders often work in tandem when it comes to penny stock promotions. This type of penny stock scam is known as the "pump and dump."
"Many times analysts take large cash payments in return for providing glowing coverage, or they receive shares that they can quickly unload after they trigger their intended buying spree," Fitz-Gerald said.
Meanwhile, investors are left with huge losses. Sometimes they lose their entire investment.
The newest variation of the pump-and-dump scheme involves a "misdialed" call from a stranger. The stranger leaves a "hot" investment tip for a friend on an answering machine. The message is designed to sound as if the speaker didn't realize he or she was leaving the hot tip on the wrong answering machine. A message like this is not a wrong number, the SEC warns. Instead, it's from someone being paid to leave these messages.
Fitz-Gerald shares these three traps not to scare investors entirely away from penny stocks, but to make sure they know the risks. The best penny stocks, Fitz-Gerald says, can "be a great compliment to a disciplined investment strategy."
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