6 Mistakes in Penny Stocks
by Peter Leeds on March 26th, 2015
The majority of penny stock investors are guilty of these costly mistakes, and that probably includes you. Even subscribers of Peter Leeds Stock Picks, who have access to industry leading guidance and trading articles, will fall victim to many of these issues identified below.
However, by identifying these dangerous errors, you can stop repeating them, and become a greatly improved penny stock trader.
Here are the 6 things you're doing wrong with your penny stocks:
1. Not calling the company.
2. Poor position sizing
3. Buying without scaling in
4. Investing too soon
5. Failing to recognize the true competitors
6. Being a "fickle fish"
1. NOT CALLING THE COMPANY
"Ask questions and be a fool for fifteen minutes. Don't ask, and be a fool for life." - Chinese proverb
This is simply the most powerful tool to give you an investment edge, yet the vast majority do not take advantage of it. Call the company, ask them questions, make sure you understand management's strategy and outlook, and see what to expect in the coming months.
Just about every publicly traded penny stock company has a designated Investor Relations contact. Their job is to speak to current and prospective investors and answer any questions they may have.
You might be surprised how much you can learn about a company, and how quickly, that you could never have gleaned through reading the financials, press releases, or their web site.
So why do so few take advantage of the Investor Relations contacts? My guess would be that people aren't sure of what to ask, or they don't feel entitled to do so. Maybe they are concerned that they might sound stupid.
I can't really know, but I will tell you that it makes a lot of sense to make a quick 15 minute phone call to get an idea of the prospects and direction of a penny stock company that you are about to invest in. Even better, follow up once or twice over the following year, checking in just to make sure everything is still on track with the business plan.
Before you do make that call, you should:
- know what you intend to ask
- know who you are talking to (name, title)
- have a thorough knowledge of the company
You shouldn't ask things that you could learn from their public releases, financials, or web site materials. That is just being considerate for the time of the Investor Relations contact.
When you are ready to take it a step further, you should even have similar conversations with the IR contacts of their closest competitors. Don't say you are calling to see if you should invest in the other company, but rather pretend to be an interested investor in their shares.
- You have had increasing revenues over the last couple of years. Do you expect this trend to continue, and what will be the key drivers to make that happen?
- Your employee count has gone up from 10 to 20 in the last year. How many employees did the company have 5 years ago?
- Of your 8 salesmen, how many have been with the company for less than a year?
- If the company has a million dollars in excess capital, would that go towards R+D, paying down debt, or elsewhere?
- Your competitor is putting out press releases about their upcoming release of their newest technology. What do you know about that technology, and how will your company respond to it's release?
2. POOR POSITION SIZING
"You eventually lose all that you gamble with." - Chinese proverb
Position sizing is one of the most important concepts in investing in penny stocks. I will simplify it as much as possible, since it's a complicated topic. The purpose is to avoid ever taking debilitating losses.
Contain the damage for any one mistake, and you live to fight another day. This requires penny stock investors to keep investment levels per trade small, and to exit quickly if the shares start going south. This is what all professional traders do, yet the vast majority of people have never heard of the concept of Position Sizing.
If you bet 100% of your money every time you traded, you eventually would end up broke, even if you were right 99 times out of 100. That's because you put all your money into each trade, and the losing trade would wipe you out.
If you bet 50% of your money each trade, any loses would be very costly, even if you had a high frequency of winning trades. Even the best traders have a few bad trades in a row, from time to time.
If you are able to make a series of 10 or 20 winning trades without taking a loss, then you certainly don't need this article. However, being realistic, you will make your mistakes, and have your successes. The idea behind Position Sizing is to limit the damage you'll incur from those losses.
Position Sizing in penny stocks has two facets:
- limiting losses when penny stocks start falling
- limiting the percentage of your portfolio invested in any one penny stock
For example, a Position Sizing strategy of investing 10% of your holdings into 10 different stocks, and selling immediately if any of these shares drops more than 10%, will be very effective at preserving your capital. The most you would lose on any bad trade would be 1% of the overall value of your holdings (10% of portfolio, sold at a 10% loss = 1% of total value).
On the other hand, a Position Sizing strategy of investing 25% into 4 stocks, and selling if you took a 25% loss, would be much less effective. On a bad trade, you could lose over 6% of your total portfolio (25% of portfolio, sold at a 25% loss = 6.25% of total value).
In general, if you have a $5,000 portfolio for penny stocks, it might make sense that you invest 10% or 15% per penny stock that you buy. If you have a $20,000 portfolio, it makes sense to invest 3% to 5% in any one penny stock that you buy.
Position Sizing can be accomplished in terms of:
- percentage of portfolio per investment
- dollar value per investment
- number of shares per investment
The idea of Position Sizing is to limit all losses, so that any mistake is contained to a small percentage of your total investment dollars. This allows you to make plenty of mistakes without getting significantly impacted.
3. BUYING PENNY STOCKS WITHOUT SCALING IN
Most less experienced traders buy and sell all at once. They have $3,000, they find a penny stock that they like, and they invest all $3,000. Anyone who knows my story will understand that I learned this lesson the hard way when I first got started out.
More advanced traders in penny stocks have a more effective strategy. They scale in and scale out of their positions. Simply put, the $3,000 in our example would be invested in 2 or 3 or even 6 chunks, and these buys would happen over days, or weeks, or months.
Let's say you have $6,000 and you want to invest it into ABC Company. Instead of putting $6,000 into the company immediately, you only invest $2,000 at first. If that stock starts going higher, the two thousand dollars is in a profit position.
If it starts going lower at least you've saved the loss that the other $4,000 would have taken. At that point you could also consider investing the $4,000 that is still on the sidelines.
This strategy has been employed since turn of the century military tactics. A good general always holds back some of his troops, and can then respond based on the results of the first attack.
By scaling in, you stay dynamic and keep your options open. It also buys you time. Time to think about the decision you made, and maybe rethink what you are doing with the rest of the money. It also gives you time to see what other events have occurred in the meantime.
For example, you might scale in with a buy in February and come back with a secondary buy in July, and a third buy in September. In between each of these purchases, you have time to assess the situation and see new events that occur with the company, with the competitors, and with the overall market and industry. You will simply be more informed.
It also keeps your money on the sidelines so that you are open to other ideas. Say you were going to put $6,000 into ABC company, but instead you decided to scale in, and you held $4,000 back. Then perhaps another opportunity comes to light, or maybe your kid needs braces so you use the money for the orthodontist. The downside to scaling in with penny stocks is that your broker commissions will be higher, but that's not really a big deal since most stockbrokers charge such low commissions that they are almost negligible.
You may also want to scale out. It's not usually a good idea to dump your shares onto the market all at once, unless you only have a very small position in the company. With thinly traded penny stocks, unloading even 25,000 shares could push the stock price down while you are selling.
A lot of people use the very common, and somewhat effective strategy, of selling half of a position if their penny stock investment doubles. This gives you back your original investment, and then the idea is to let the other half ride. I find it more effective to exit and enter positions in three, four, or even eight different trades, as long as you are doing it with enough money each purchase to make it worthwhile. I usually space these purchases out over months, and sometimes years.
I bought Absolute Software at 80 cents. It scared me by immediately going down to 40 cents, but Leeds Analysis gave me a lot of clarity on this penny stock's direction, so I did not worry.
Soon Absolute reversed, and within the next two years approached $8.00 per share. I sold three different chunks near the seven dollar mark, around these different prices and in different months.
It's also a good idea to scale in or scale out surrounding an event. For example, a company is going to release their financial results, and you expect the numbers to be strong. You might want to buy shares with part of your capital before the release of the financials. Then you keep part on the sidelines, until you see the actual results. At that point you can decide if you want to put the rest of the money in, or perhaps now you've changed your mind.
4. INVESTING TOO SOON
You see this often, especially with penny stocks. In fact, it was my own personal million dollar mistake. People jump on board a company that has a good story, but they often do this years before that story will fully play out.
With penny stocks, there's getting in early, and then there's getting in years too early!
Picture a biotech company working on a treatment for a major disease. Excited investors realize that if the company is successful, they will own the lion's share of a multimillion dollar market. Makes sense to jump in now, while this penny stock is still undiscovered, right?
Wrong. Every minute that your capital is invested, it is at risk. At risk of new competition arising, law suits popping up, poor financial results, an overall downturn in the industry, a stock market collapse... the list goes on and on.
As well, any business plan requires several years to come to fruition, and just about any strategy generally takes a year or two longer than planned.
Most investors, even ones who turn an impressive profit, buy into a penny stock, then sit and wait for months and years. When you find a company that you like, remember that you've got plenty of time. Watch and wait, keep an eye on the penny stock company, and scale in over the course of the months and years leading up to some major progress.
5. FAILING TO RECOGNIZE TRUE COMPETITORS
Imagine if there were only two companies in North America that sold electric scooters. The belief of both of these businesses, as well as the beliefs of investors, might be that their competition is the only other electric scooter company in America.
Well, this penny stock's competition will also include any gas-based scooters, so these should not be ruled out.
As well, in today's increased globalization, the company and investors need to be wary of competition coming from overseas. Yet, is that the final extent of their competition?
These penny stock scooter companies are also up against bicycles. Motorcycles. Cars. Walking. But it still doesn't end there.
An electric scooter company needs to be aware that they are also competing with taxis, buses, and subway cars.
Will a prospective electric scooter customer refrain from buying simply because they can take a taxi? Probably not. However, they might put off a purchase if the electric scooter is just one of a variety of options.
Who is the competition for McDonalds? It's not just Harvey's, Burger King, and Taco Bell. It's also high end restaurants, pizza shops, and grocery stores.
Who's the competition for 6 Minute Abs? Other exercise equipment gimmicks. Who else? The local gym. Who else? Home exercise videos. Fat burning pills. Weight loss programs. Liposuction. Not exercising.
By taking the total view of all competitors, you get a better idea of what each penny stock company is up against. A lot of competition doesn't necessarily mean that a company has no chance. However, it does demonstrate the importance of differentiation, and a "unique selling proposition." If you get a clear understanding of the entirety of potential competitors, you will suddenly have clarity about whether of not the company in question is doing enough to survive against the other penny stocks and large blue-chip companies.
6. BEING A FICKLE FISH
"If you chase two rabbits, both will escape." - Indian proverb
This is also known as over-trading. You jump from one penny stock investment to the next, take commission fees, miss out on gains in the other penny stocks, and continually chase the latest hot opportunity.
This rarely works out well, and usually will cost you in penny stocks. It is a reactionary trading style based on impatience, lack of focus, and distraction. The investment world's version of "the grass is always greener on the other side."
Being a fickle fish means that you forget about the reasons you bought a penny stock in the first place, are easily enticed by other options, and fail to let the underlying company's business plan play out before you jump ship.
It has been proven that the penny stocks that investors leave behind subsequently increase in price more than the new investments that person makes. Traders would have been better off by holding the shares they already had, than by jumping into the new ones.
Even when the market does well, and being a fickle fish brings you a profit in penny stocks, it is usually not as good an approach to investing as you think. Consider this scenario that you'll see among fickle fish when the market is roaring higher:
Our fickle fish friend (we'll call him Steve) buys ABC Inc. He nets a nice 10% profit over a few months, then sells and puts the profit into DEF Corp. After enjoying a 20% rise, he switches his money to GHI Ltd. Profits there, then moves to JKL Inc., and finally profits from MNO Holdings.
Steve comes to you to brag about all the trades he's made, and shows you that overall he's up 100%. Making 5 profitable trades in penny stocks has seemed to work pretty well for him, especially in this bull market.
That is when you get to have some fun with Steve. You show him how ABC Inc., the stock he bought in the first place, is also up 100% from where he first bought it. His 5 trades were not any more effective than just buying and holding the first penny stock in the first place!
HOW TO CORRECT THE 6 MISTAKES IN PENNY STOCKS
The first step to overcome these investing errors in penny stocks is awareness. Now that you know to watch out for these issues, you are a lot more likely to avoid committing them in the future.
You may even be able to look at your own trading style, and remember several incidents of when you fell victim to "The 6." This will only serve to reinforce the message even further.
Lastly, each of the six mistakes in penny stocks requires a different approach to overcome it. In penny stocks, do what is required to develop a trading methodology that works in your interests, helps you reach your goals, and makes it easy for you to sidestep the pitfalls we've discussed here.
Thanks for reading, and as always, we remain committed to bringing you the absolute best in penny stock picks!