Where to find penny shares

David Thornton explains what penny shares are, and where to find small-cap stocks to invest in.

Penny shares' is a loose term that broadly speaking applies to any share that has the potential to make you a very large amount of money. Of course they will not all succeed, but they do at least offer that possibility. The shares that I write about in Red Hot Penny Shares really fall under two definitions. Either they are young companies that could achieve rapid growth, or else they have a low share price. Or both!

a) Young companies

All of today's big companies started out long ago as somebody's good idea. They will typically have gone through four phases.

First of all there is the initial phase, during which the good idea is developed. The company is more about an exciting concept than anything tangible, but this can be a profitable time to invest.

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The second phase is trickier. It involves moving from concept to launching a product. Often the early excitement gives way to real-world development delays and requirements for more capital. I call this the cold light of day' phase and it can be tricky for investors.

Third comes the growth phase. By now the product is launched, it is selling well and in increasing numbers. More investors come on board and the story becomes better known this is also a good time to be an investor.

Finally the company reaches maturity. Now every possible customer for the product has already bought one; competition may have emerged; or the product may have been overtaken by a new technology. The only problem is, no-one tells you it's phase four. You have to spot this yourself, making sure you stay on board long enough to enjoy the fruits of growth, but get off before prospects turn stale.

There are hundreds of early stage companies quoted on the stock market, particularly on AIM. This is as it should be, because the stock market has two purposes: one is to provide a market place where investors can buy and sell shares; the second is to allow companies to raise money. They will sell a share in their business to outside investors in return for the money that they need to progress their plans exactly the same thing that happens in the TV show Dragons' Den'.

Every year, many companies choose to list on the stock exchange, usually to raise new capital. They need this capital for all sorts of reasons: to build a factory; to progress their research work; to hire a marketing team; or to buy the raw materials that they need. In the case of mining ventures, they need cash to dig the holes in which they might find precious metals.

So the opportunities to get into new companies are several, and come in a constant stream.

b) Low share prices

Suppose that a share in company A costs you a penny, but a single share in company B costs £10. So you can buy 1,000 shares in the former for no more than the cost of one share in the latter.

Many people would rather have 1,000 shares in a company than just one. But this is a common misconception. The actual price of a share tells you nothing. The share price is simply the product of the number of shares in a company and its value. Company A and B might both have a value of £1m. The only difference is that company A has 100 million shares in issue, but there are only 100,000 shares in Company B.

All the same, when companies come to the stock market for the first time they can set their own share price (altering it simply by issuing more or fewer shares) and they generally choose a price that is relatively low, often below £1. So if a share price is £5 or £10, the chances are that it has got there by going up over time from a lower level. There is no reason why it should not continue to rise, but clearly if a share price has moved from 50p to £5, one would rather have bought it at 50p than to be buying it now. So by sifting through low-priced shares we are more likely to find shares that are yet to make a major move. We are also likely to find shares that have previously been trading at much higher levels. This brings us into the realm of recovery stocks'.

Corporate life never runs smooth. All companies are affected both by external events that they cannot control, and internal events that they could control but might not manage to. A simple example of the former would be the interest rate cycle, which affects house prices. The profits housebuilders make are directly related to the prices at which they can sell houses, so if interest rates rise and house prices fall, there is not much that a housebuilder can do except sit and suffer. Plenty of housebuilders have their shares quoted on the stock market, and as the downswing of the cycle brings their share prices to low levels, we are presented with a good chance to buy them and benefit from the subsequent recovery.

This type of external pressure on a share price is relatively easy to spot and to monitor. Far more difficult are happenings within a company. Unfortunately, company directors do not always do predictable things, or things that are very sensible. They might fall out with their major customer; they might see their key staff depart for a rival; they might fail to invest in their product and see it overtaken by a competitor; they might find that a customer cannot pay its bill. But the two self-inflicted wounds that are most common are duff deals and unfulfilled expectations.

When private companies choose to go public and have their shares listed on the stock exchange, they are obliged to employ various highly-paid advisers. Once they have achieved this new status they find that these advisers are only too keen to extract even more fees. Nothing generates fees more than a deal in which one company acquires another. So City advisers promote the idea of such deals, and all too often they find that the directors, proud of their new status in charge of public companies and fancying themselves as gladiators of the corporate scene, are ready to listen and to act.

Listen to those who have never got outside the world of spreadsheets and financial forecasts and you would think that merging two companies together is a piece of cake. But in reality it involves a lot of work, a very careful plan, and above all considerable diplomacy to ensure that staff and customers go along with the idea. All too easily things can go wrong, and this is one of the most common reasons why the high expectations of shareholders can be disappointed.

It is absolutely vital to understand that a share price at any time incorporates a set of expectations. And nothing upsets the City more than a company that falls short of these expectations. The City expects a company to deliver the profits that are forecast, and to progress at a certain rate. The fact that business life never runs entirely smoothly and according to plan does not seem to occur to brokers and investment managers. They expect companies to deliver, and that is that. So if a company dares to admit that it might not quite make the forecast profits, and might have slipped a few months behind schedule then the wrath of the City descends upon it and its share price is sunk. If you hold shares in the company at this time you suffer. But if you do not hold shares then this can be a great time to buy. You can buy the shares at a low level, and benefit from the subsequent recovery as the company gets back on track and City sentiment thaws.

So the stock market is continually offering you and me the chance to buy shares at a low level. And if we take the best of these opportunities we will profit either from the subsequent growth of the company or from its recovery.

To give you an idea of just how deep the pool is in which we can fish, take a look at this table:

Swipe to scroll horizontally
Over £2bn151£1.9trn83.97%

Source: London Stock Exchange main market and Aim fact sheets, September 2014

What this shows is that 85.1% of the combined value of all the 1,920 companies quoted on the Stock Exchange is accounted for by the 142 largest of them. But at the other end 1,428 companies' account for just 3.2% of the total combined value. So there is a very long tail of small companies, all largely ignored by professional investors. Remember, professional investors have billions of pounds to invest. So it just does not make sense for them to waste their time looking at companies that, however attractive, are simply too small to absorb more than a minute fraction of their funds.

But there is nothing at all to stop private investors from investing in these small companies. In fact it makes perfect sense. By doing a bit of our own research work we can gain some competitive insights. And we know that if our chosen companies are successful they will graduate up this scale until eventually they are large enough to attract the attention of the pros.

This is a real treasure trove. Amongst these several hundred small companies are some real winners. In fact amongst them could lie the next Google! Within this list we will find companies from every corner of commerce: mining, electronics, medicine, property, food, retail, oil and many, many more.

And it is a list that is being constantly refreshed. Each year up to 300 new companies, both from the UK and from overseas, choose to have their shares traded on the London Stock Exchange. To give you a flavour recent new listings have included a leading provider of hospital services in Abu Dhabi and a company that provides the technology for slot machines.

The question, then, is: how to select the good ones

That is where I hope Red Hot Penny Shares can help.

Red Hot Penny Shares is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares; never risk more than you can afford to lose. Pastperformance is not a reliable indicator of future results. Please seek independent financial advice if necessary. Customer Services: 020 7633 3600.

David Thornton is a small cap share expert with over 30 years’ experience in the investment world. He was an equity fund manager at Henderson Global Investors for 17 years, and in 2006 he launched the Matrix New Europe Fund, investing in equities throughout Eastern Europe, Russia and Turkey.