The penny stock sector is a great place to make market-beating returns on inexpensive stocks. But it's crucial to learn our two penny stock investing tips before adding these stocks to your portfolio.
You see, penny stocks attract investors because they can give you double or even triple-digit gains in a matter of weeks. For example, MoSys Inc. (Nasdaq: MOSY) – a California-based semiconductor company – has soared 198.5% from $0.66 on June 1 to $1.97 today (Thursday, June 22).
But many penny stocks can see tremendous triple-digit returns without the financials to support them. A recent example is Hongli Clean Energies Technology Corp. (Nasdaq: CETC), a Chinese energy company whose shares surged 144% from $1.90 to $4.63 in just the first week of April.
However, the stock's trading was halted after that, and the firm is now undergoing a class-action lawsuit for misleading its investors. According to info from the Nasdaq exchange, Hongli allegedly provided false financial info to investors, a charge that could cause the stock to be delisted and possibly result in CETC investors losing their capital.
Companies like Hongli are the perfect example of why you need to be careful with penny stocks. According to Money Morning Chief Investment Strategist Keith Fitz-Gerald, they should never make up more than 2% of your total portfolio. Even then, investors need to decide if they can handle any exposure at all to these typically volatile investments.
That's why we're here to give you two tips for finding the best penny stocks to buy. Then, we'll give you one of Money Morning Small-Cap Investing Specialist Sid Rigg's top small-cap stock picks this year.
Penny Stock Investing Tip No. 1: Review Executive Compensation
It's important to know the financial information of any stock you want to add to your portfolio. Penny stocks are no different.
It can be harder, though, to find financial information on penny stocks. The reason is that many trade on the over-the-counter (OTC) exchanges or the pink sheets. The requirements for financial reporting on these exchanges are much less rigorous than those on either the New York Stock Exchange (NYSE) or the Nasdaq.
However, all exchanges require companies to submit annual 10-K filings. These are the key to finding out whether or not a penny stock is safe for your money because they provide one important piece of information: executive compensation structure.
When looking at a company, knowing if its upper-level executives are paid in cash or stock options is extremely important. If they're being paid in stock options, it indicates that they have faith in the firm's performance and intend to stick around for the long haul.
If they are being paid in cash, it's a major cause for concern. Choosing to be compensated in cash rather than options shows these managers do not have faith in the company's long-term performance. It also indicates they may just be trying to cash in on the firm before it ultimately files for bankruptcy.
This all boils down to one simple rule: Don't put your faith – and hard-earned money – in a company if its employees don't put theirs in it.
Penny Stock Investing Tip No. 2: Know the Signs of a Pump and Dump
One of the most common types of penny stock scams is the "pump and dump."
In this scenario, salespeople aggressively promote the stock in various ways. These can include cold-calling random people, mailing out informative pamphlets, and sending spam emails. All of these forms of communication hype a particular company as a great investment opportunity.
The purpose of this promotion — the "pump" — is not to let investors in on a golden egg. It's to get investors interested enough to the point where they buy shares of the company and the stock price starts to rise. A climbing stock price is the whole point of the scam.
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Once the stock price has risen enough, executives and early investors who already own the stock are going to sell shares to get a profit based on the promotion-fueled rally. This massive sale of shares by insiders is the "dump," and it allows them to make a huge profit while leaving the duped investors with big losses from the plunging stock price.
The best way to avoid falling victim to one of these schemes is to never buy a stock that's being aggressively promoted to you. Don't rely on the word of a salesperson, no matter how tempting the story might be.
While there are plenty of safe penny stocks out there, avoiding getting ripped off requires you to do an extensive amount of research. 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 the year.
Even though shares of this stock are above the $5 cutoff for penny stock classification, it's worth a look as analysts predict it could gain as much as 25.7% over the next year.
Here's Sid's newest small-cap recommendation…