Buying penny stocks can be a cheap way to make big profits in 2017. However, investors need to understand the high risk associated with penny stock investing and whether or not their portfolio can handle it.
You see, one of the main attractions of penny stocks are the cheap shares. They trade for under $5 per share, which means any significant price increase can provide investors with explosive returns in a short period of time. But these huge gains can often be the result of a pump-and-dump scam or financial fraud.
For example, Hongli Clean Energies Technology Corp. (Nasdaq: CETC) skyrocketed 143.7% from $1.90 to $4.63 in just the first week of April 2017. However, the stock's trading was then abruptly halted when the Nasdaq exchange requested additional information from the company. And on June 2, global investor rights law firm Rosen Law Firm filed a class-action lawsuit against Hongli for misleading investors through false financial information. If Hongli is found guilty, its stock could be delisted from the Nasdaq, and CETC investors could potentially lose their money.
Hongli is the perfect example of the inherent risk associated with penny stocks, even those that trade on major indexes. Still, if you want to invest in them safely, you're much better off sticking to firms that trade on major indices like the Nasdaq and NYSE than on over-the-counter (OTC) exchanges or the Pink Sheets. Since those exchanges aren't regulated as much as the Nasdaq and NYSE, they can be much riskier.
Penny stocks should also never account for more than 2% of your total portfolio. That's just one of the tips we recommend here at Money Morning.
Here are two more rules investors must follow for safe penny stock investing...
Penny Stock Investing Tip No. 1: Understand the 10-K Filings
When you research penny stocks, it's important to dig into the company's financial filings first. These allow you to get a firsthand look at the company's profitability and overall health.
An important document to look at is the firm's 10-K filing, an annual report required by the U.S. Securities and Exchange Commission (SEC). A 10-K is helpful because it offers information on executive management and the firm's compensation structure.
If the company's executive team is being paid in cash as opposed to stock options, this is a major red flag. Opting to be paid in cash instead of stock options indicates the managers don't believe in the long-term success of the stock. Even worse, it shows they may be trying to cash in on the stock before it crashes and the firm goes bankrupt.
If the 10-K filing shows that management doesn't believe in the company's performance, there's absolutely no reason for you to invest in it.
Penny Stock Investing Tip No. 2: Be Vigilant of Pump-and-Dump Scams
Small companies looking to boost their stock price will sometimes pay for deceptive promotions. When executives own shares in the company, they will then sell those shares at the newly inflated price, causing the stock to tank and leaving new investors with massive losses.
This method of using deceptive advertising to generate interest in a stock before selling at a higher price is called "pump and dump." These schemes are dangerous for both new and the most seasoned investors because they promise rich rewards but end up cheating you out of your money.
While pump-and-dump scams can cause you big losses, there are three easy ways to detect them...
The first is the "wrong number" trick. Sometimes, a scammer will purposefully call a wrong number and leave a voicemail for a "friend" with a hot stock tip. This is meant to lead people to believe they've gotten lucky and stumbled upon a good investment opportunity.
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Another sign of a pump-and-dump scam is mailed pamphlets in both physical and electronic form. While physical pamphlets falsely promoting a new stock aren't as common anymore, e-mailed newsletters hyping up a new stock are commonplace.
But with the advent of Internet communities in recent years, pump-and-dump scams commonly happen through online investment forums. Someone can take a large position in a stock that trades on low volume, which in itself will pump up the price. Then, they only need to begin asking questions about the stock online to get other investors interested and eyeing the stock. Once the stock's buying pressure appears ready to drop, the original perpetrator can easily dump their shares for a big return.
While there are plenty of reputable penny stocks that you can invest in, not getting taken for a ride requires that you remain on guard and do an extensive amount of research. Money Morning Small-Cap Specialist Sid Riggs understands that this is a lot of work, which is why he's done the legwork for you and provided a small-cap company that's one of his favorite investments of 2017.
Even though it is slightly more expensive than the average penny stock, it's worth a look as analysts expect it to return as much as 30.9% over the next year.
Here's Sid's newest recommendation...
This Small-Cap Stock Could Hand You a 30.9% Profit by Next June
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Mitek Systems Inc. (Nasdaq: MITK) is one of the best small caps to own this year. That's because it has a huge presence in the growing financial tech - or fintech - market.
According to Sid's research, the mobile transaction market is growing at a stunning clip, expected to expand by 716% through 2021. Not to mention total revenue for tech firms making those transactions happen could soar as high as $865 billion.
As a firm that develops software used for mobile banking transactions, Mitek is set up to profit handsomely from that market's expansion. The company's services let users do things like pay insurance and deposit checks.
Sid firmly believes the banking industry's shift from brick and mortar to entirely mobile makes Mitek a great long-term investment.
"Millenials - and everyone else for that matter - are embracing mobile bank deposits whereby a user can simply take a photo of a check and upload it straight to the bank rather than having to trudge to the branch," Sid said.
The company's recent earnings growth shows how the firm's bottom line is benefiting from the industry change. Mitek's net income went from a big loss of $5.3 million in 2014 to a profit of $1.9 million in 2016. Even more impressive is its $1.2 million income in the first quarter of this year alone. That was up a huge 109% from Q1 2016.
According to Thomson Reuters-surveyed analysts, Mitek's earnings growth won't slow up this year. They see the firm posting an average 2017 EPS of $0.29 - up a whopping 383% from $0.06 in 2016. Those same analysts forecast the MITK stock price to hit as high as $11 per share by June 2018. That would be a gain of 30.9% from the current price of $8.40.
And if the fintech market grows by Sid's expected 716% through 2021, analysts could certainly raise the price targets - and that 30.9% profit would just be the beginning.
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