Penny shares to profit from in 2007

Tom Bulford, editor of the Red Hot Penny Shares newsletter, looks back at his tips for 2006, and picks his top stocks for 2007

I have one safe prediction for 2007: it will be another year of thrills and spills for small-cap investors. Some more specific penny share tips in a moment, but first let's look at general themes for this year.

Penny shares: Aim will drag its feet

I wish I could predict a better year for the Alternative Investment Market (Aim), but my hopes are not high. While the FTSE Small Cap index of relatively well-established companies rose 13% in 2006, Aim is in fact down 1%. This high risk, high reward' market is actually a high risk, low reward' market. But City professionals are too busy counting their fat fees for floating new companies on Aim to worry about what happens afterwards.

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Meanwhile, fund managers make too many investment decisions based on tax considerations and too few based on real analysis of, and enthusiasm for, the company concerned. So expect Aim to drag its feet once again and, in the words of the drowning fund manager, "stock selection will be critical".

Penny shares: exploration stocks

There are now 271 mining and oil plays on Aim, up from 234 at the start of the year. But the flood of money going into new mining ventures a year ago has turned into a trickle. A long and painful sorting of the wheat from the chaff has begun. Mergers will cut the number of natural-resource wannabes some have already taken place. However, these stocks won't rise until they start to deliver actual production, revenues and profits. That may take several years and what will the price of oil or metals be then?

Penny shares: opportunities in foreign companies

Not unconnected with the rising number of resource stocks has been the growing number of foreign companies listed on Aim. Of the market's 1,595 stocks, 294 now come from outside the UK, thanks to the London Stock Exchange's enthusiastic but misguided effort to make Aim the global market for small companies. The problem is that City investors are a good deal less cosmopolitan and their reputation for judging and valuing global business is much over-estimated. Until Aim becomes a market place where global firms can meet global investors, foreign companies will continue to complain of being undervalued and misunderstood.

But the good news is that this is likely to throw up opportunities to buy good companies at low prices. Some foreign stocks have failed spectacularly Burst Media (from 90p to 18p) and Cosentino Wines (140p to 14p) are two examples. But it's wrong to tar them all with the same brush, so one of my 2007 selections is SQS (SQS), the first German Aim entrant.

Penny shares: the next Aim bubble to blow

Apart from body blows from certain foreign stocks, Aim has been hit this year by an inevitable relapse in resource stocks and the equally inevitable collapse of the gaming sector. So what will be the next vortex to swallow investors' money?

The best bet has to be alternative energy. Give the mug punter enough headlines about melting ice caps, fuel shortages and our dependence on gas from Russia, and he will leap into any firm that promises to create, trade or save energy. Plenty of vehicles will be set up to tap into this and many will disappoint.

Give me a company that churns out profits and dividends any day, rather than one that has a great idea but is yet to deliver. The small company sector is full of the latter, and investors fall for them every time.

Penny shares: the return of the technology bull

Sector-wise, I am wary of media, where things are changing too fast to have confidence in any business model, whether to do with creation of content or its delivery. I am also wary of financials, which have had a spectacularly fat year, and of the many groups that have splurged on eastern European property. The security industry is more promising products for both national and personal security remain in hot demand; and we will hear more about nuclear power and decommissioning old plants.

The one area I really like is IT. While the 2000 tech bull was based on hope and hype, we are now seeing the survivors prove their worth. IT is far from a luxury it's now the cornerstone of any successful business. I especially like the software sector, where there are several great little firms that have customers who absolutely rely on them. Document management group Invu (NVU), insurance software provider Sirius Financial (SIR), and Bond International (BDI), which has world-leading recruitment software, are three of the best. Another, Touchstone (TSE), is one of my tips for 2007.

So the lessons of 2006 are to mistrust promises; rely upon profits and cash generation; be wary of new issues; and recognise that in an overcrowded market, only companies that do what they say on the tin will have any chance of impressing investors. With these lessons ringing in my ears, here are 2007's top five.

Top five penny share tips

Autoclenz (ACZ, 123p)

This is the sort of firm I love. Autoclenz cleans cars for motor dealerships and car rental firms. The market is growing as outsourcing increases and Autoclenz is increasing its share. A small subsidiary, Smart Repair Services, is growing even more quickly. It fixes small dents and scratches on site, saving the owner a trip to the body shop. The group has little need for capital investment, yet it trades on a 2007 p/e of less than seven and offers a rising dividend yield of 4%.

SQS Software Quality Systems (SQS, 202p)

SQS is Europe's leading software-testing company. A good 70% of software packages fail to meet expectations because flaws are not spotted early enough, and this is the problem that SQS addresses. The group posted full-year organic growth of 18% in September, continuing a solid track record. With the German markets in hibernation, it chose to become the first German group to have its main listing in the UK and has bought a complementary UK company, Cresta Group. SQS clients include Vodafone, Airbus, Deutsche Telecom and Siemens, and the upturn in the German economy can only help it to meet 2007 earnings per share forecasts of 18p, which puts the shares on a p/e of 11.

Sovereign Reversions (SVN, 365p)

Sovereign Reversions enables the asset rich but cash poor to turn some of their bricks and mortar into cash. It offers home reversion plans, which differ from the more common lifetime mortgages. Under the latter, home owners take out a loan secured against their property. Under a home reversion plan, they sell part, or all, of their home in return for a lump sum, but continue to live in it until they die or move out. Home reversion plans have a small share of the market, mainly because they are unregulated.

However, as of April 2007 the FSA will start regulating them, which will encourage IFAs to recommend them. Hence Sovereign expects its growth rate to rise, while for the time being the shares trade at a 20% discount to the embedded value of its assets. You need to be really bearish on house prices not to find this a bargain.

Touchstone (TSE, 180p)

Touchstone, a small software and computer services group, is in the right place at the right time. In 2001, chief executive and controlling shareholder Keith Birch recognised that Microsoft's vast budget and determination to get into the Enterprise Resource Planning sector would make it a major player. His firm decided to focus on Microsoft applications and is now reaping the rewards.

It also specialises in a hot area of the software industry: Spend Control'. Until now, finance directors of large organisations have found it hard to control spending. But online ordering and authorisation can give them this control. With the Gershon Review pressurising the public sector to control spending and private firms seeing obvious advantages, Touchstone is very busy. It is expected to report earnings per share of 18.5p in the current financial year, putting the shares, which also pay a dividend, on a p/e of just ten.

GoIndustry (GOI, 18p)

For speculators, GoIndustry is my tip for 2007. The group is doing for industry what Ebay has done for you and I. It runs an online auction site and every day sells second-hand industrial machinery from all over the world. Its biggest deal to date was the sale of a $3.9m Philippine textile mill to a buyer in India.

Big companies, always keen to find ways to become more efficient, are realising that they have unused machinery they can easily turn into cash. So this trading mechanism is now creating a whole new business opportunity. GoIndustry is expected to make a pre-tax profit of £2.6m in 2007 and is valued at £35m. While this means that the company isn't cheap, the business requires minimal capital investment and has big potential.

So how did Tom's 2006 tips perform?

Last year's penny share tips have produced the usual mix of surprises, but we've come out with an average gain of 26%. So what should you do with them now?

Servicepower (SVR): 56%

This will teach me not to be swayed by promises of jam tomorrow from a serial disappointer. The firm's technology may help servicemen to reach appointments on time, but the group has yet to arrive at the station called profit. I've given up on this one. Sell.

European Minerals (EUM): 19%

European Minerals' gold/copper mine in Kazakhstan has met with inevitable cost overruns and delays; production will now begin no earlier than the end of 2007. But having travelled this far, I would hold, subject to the usual warnings that cover new mining projects and countries ending in stan'.

Colliers CRE (COL): +26% (performance adjusted, assuming take-up of rights issue)

The shares racked up a 70% gain by the end of May before a £16m rights issue stopped them in their tracks. Colliers CRE is part of a global affiliation, an unusual arrangement that makes them a little difficult to value. But it trades at a hefty discount to rivals Savills and DTZ, and providing property advice is a booming global industry that the British are rather good at. Buy.

Computer Software Group (CSW): +72%

The firm has delivered on its promises. It has bought other niche software providers, and accelerated growth through cross-selling. CEO Vin Murria is eyeing up further acquisitions, and this growth story is a long way from its final chapter. Buy.

Christie Group (CTG): +109%

Shares have soared but not for the reasons I expected. While Christie's long-term loss-maker, its retail software unit, is apparently no closer to turning a profit, its traditional activity of valuing businesses has prospered from the takeover boom. This looks too good to last for ever and shares are now pricey. Sell.