29 Point Leeds Analysis for Small Stocks
With any stock market investment, you should remember that you are buying shares of business. The underlying stock will typically behave as a reflection of the successes (or lack thereof) of the operations.
With smaller, more "fragile" shares, the depths and approaches of the analysis needs to be handled very methodically. Enter Leeds Analysis, the industry's accepted and trusted method of putting small shares "through the ringer" before you ever risk a single penny.
For the first time, we provide a general look into the Leeds Analysis process. Our 29 point review is responsible for discovering the highest-quality, low-priced investments just before they make large price moves.
Leeds Analysis is about looking at any and all issues which matter to the price of any company's shares. Remember, sub-$5 stocks are typically smaller and newer businesses, so they can be easily derailed by isolated events, such as losing a major client, getting hit with a large lawsuit, or running at an operational loss for too long.
Leeds Analysis looks at all the important factors. However, it does NOT look at book value, buying and selling by insiders, and the Board of Directors. Decades of experience have shown that:
- book value is nearly meaningless in early stage and speculative investments
- insider trades have no dependable correlation to the future price moves
- the makeup of the Board of Directors takes a distant back-seat to a company's market, Executive team, and business plan
Part One - Fundamental Analysis (FA)
FA makes up 80% of our efforts, and is the most important aspect of looking into any company (not just penny stocks).
1 Trends in Profits/Earnings
An investment making a shrinking profit will be outperformed by one with a shrinking loss. In other words, bad numbers which are improving are heavily preferable to good numbers which are getting worse.
In other words, revenues and expenses matter for any business. However, much more important is the trend in those factors.
Losing less and less money slowly over time is much better for shareholders than a stock which is making a shrinking profit.
2 Trends in Market Share and Market Size
A growing market is great for all businesses operating in the space. It is even better for any company which is seeing their portion of that market increasing.
For example, if the annual market for cotton candy is $100,000, and a business takes $50,000 of those sales, then they have a 50% market share. An attractive investment would be increasing their market share every few months, while the total market also grew.
In our example, picture the cotton candy market growing to $140,000 in annual sales, with a particular company taking 65% of that potential market. In other words, they would increase from $50K in sales (50% of $100k) to $91,000 (65% of $140K). Such a scenario would mean about 80% growth in total sales, even though the total market only grew 40%.
3 Barriers to Entry
The harder it is for new competitors to get into an industry or line of business, the better for all the businesses already operating in the space. Sometimes barriers involve Government or Organizational Approvals (FDA clearance, for example), high technical requirements, limited workforce, complexity of the product or solution, Intellectual Property safeguards (like Trademarks and Copyrights), and dozens of others.
If a business is running a hot dog stand or making t-shirts, they can expect new competition popping up all the time, forever. On the other hand, if a business makes robots which perform brain surgery, they shouldn't expect many new competitors.
Typically, the higher the barriers to entry, the worse for any newcomer business, and the better for those which are already operating in the industry.
4 Financial Ratio Trends
Financial Ratios (FRs) are a great way to compare apples to oranges directly, or penny stocks against Blue Chip companies. How else would you know which company is better at producing a profit, or which is more appropriately valued, between IBM, McDonald's, and some obscure $2/share business?
FRs are simply one number divided into another, which then help give more clarity of the underlying business. FRs provide a view at a business':
For example, you probably have heard of the most common valuation ratio, the price/earnings ratio (known as P/E). When you divide the price of the shares into the company's current earnings, you can see how much you are paying for each dollar of earnings power, and thus understand which companies are more expensively and cheaply valued for investors.
Beyond the FRs themselves, the real importance comes when you look into the underlying trends. Any business which is displaying an ongoing improvement in their current ratio, inventory turnover, or gross profit margin should perform much better than one which isn't.
5 Competitive Strengths and Weaknesses
Competitive strengths can be as simple as operating in Mexico (greater sales after exchange rates, large workforce, cheaper labor, etc...), having some rock-solid trademark or patent, or even being the first mover in a space.
Weaknesses can include things such as numerous competitors, a complicated or misunderstood product (the need to educate the market is one of the most expensive marketing black holes), or even operating a retail location in a bad neighborhood.
The important analysis comes down to identifying the advantages and disadvantages, identifying which can be changed for the better, and researching which will be actually adjusted effectively based on the management team's plan.
6 Balance Sheet Realities
The Balance Sheet is the first stop we make in Leeds Analysis. Before we waste any time on further review, we use the balance sheet to eliminate the stocks of thousands of companies so we can spend more time on the businesses which will actually be around in a year.
Yes, this was not the first item we listed, but it is typically the most important - it separates the 'ideas' and 'lottery ticket companies' from the solid penny stock businesses which will actually accomplish something, and grow.
Put simply, the balance sheet will show what a business owns, compared to what it owes. Be cautious with companies which put unrealistic values on line items like "Goodwill" and then treat it like an asset. Cash is an asset, the perceived value of a company's brand name is usually not (despite what the crafty accountants will try to tell you).
7 Buybacks, Liquidity Direction, Cashflow
Keeping an eye on movements of money, and changes in the number of available shares, is very important to assess the ongoing health of a business. Buy backs, share splits, reverse splits, offerings of new stocks, etc... can all cloud the real picture.
For example, if earnings per share are increasing, but they did that after buying and eliminating half of the shares, their profits may actually be decreasing, despite appearances of growth.
Typically, issuing more share of stock into the market can help raise money for a business, but it can be detrimental for the company's share price. Meanwhile, a reverse-split is also often negative for long term momentum.
Also, when looking into cash flow, it may help to think of that as the blood in the veins of a business. Properly managed movements of money can be even more important than the income statement or balance sheet. Cash flow can buy a business years of operations, even when sales are not great, which becomes especially important with newer businesses.
8 Industry Clouds and Sunshine
The direction of the overall industry is very important. You will find that the corporations in rising sectors all rise together, and fall together in sympathy. You should know where a particular industry is headed, and get an idea what the management believes is in store for their business and industry, both in the next year, and several years in the future.
9 Political and Social Trends
If fur coats, cigarettes, and typewriters are falling out of fashion, little can be done to reverse the declines of companies operating in the space. However, if technological, social, and regulatory changes are helping certain industries, the stocks operating in the sector may benefit.
10 News Releases (both company-issued and not company-issued)
Any press release (PR) put out by a company is going to sound pretty positive. However, this does not mean that the event they are 'bragging' about isn't great - this is something as an investor you need to surmise.
At the same time, any news or PR which is NOT issued by the underlying company is a great way to gain even more clarity about the related business. For example, if a company has a PR saying they will be working with Google, you shouldn't put much trust or weight into it. However, if Google confirms they will be working with the company in their own PR, then you know the news is for real.
Warning! Lots of companies try to boost their shares by alluding to alliances, contracts, or agreements with larger, well-known entities. Typically in low-priced stocks, these are outright false or misleading tactics.
11 Alliances, Customers, Partners
Just as products which want to be high-end or premium will advertise in high-end, premium magazines, the people and organizations that a business associates with will tell you a great deal about where they are headed.
If affiliates and partners of a business are dishonest and sloppy, then the underlying company is probably dishonest and sloppy. Who they associate with is a reflection of who they are, or aspire to be.
12 Insider and Institutional Ownership
Typically, higher levels of Institutional Ownership of the shares is a positive sign for the company, because it represents mutual fund managers, hedge fund managers, and other professional investors, who have bought stock in the underlying company.
Insider ownership is also important because it shows you that the individuals steering the ship have "some skin in the game" so to speak. If insiders own 25% of all the shares outstanding, you can believe that they want to move the stock's price higher.
You do not want insider ownership to be much higher than 35%, because then they can (possibly) just do whatever they please, with no checks and balances. If insider ownership is less than 2%, you need to question why. Generally, most sub-$5 shares have an insider ownership position between 10% and 20%.
Warning! Unlike percentages of insider ownership, we do not put any stake in insider purchases/sales as a means of predicting where the shares are heading. Insiders are notoriously bad investors, buying when they should have sold, and vice versa. As well, they often make trades completely unrelated to corporate prospects or operations. Using their trades is no way to reliably predict future prospects for the underlying shares.
13 Market Risk (systemic risk)
Shares in many stocks will trade with the ebbs and flows of the overall market. When the exchanges are moving higher, that rising tide will typically lift all boats. On the other hand, a market crash can take everyone down with them, independent of the prospects of the individual companies.
Moves in individual shares, due to moves in the overall markets and indexes, are known as systemic risk. Any investment holds a certain degree of risk simply by being a part of the "system."
Our expectations for future moves in the market color our analysis to a certain degree, so our considerations for where the markets are heading must come into play.
14 Company Risk (non-systemic risk)
Non-systemic risk is the potential downside of any company, based on factors specific to that particular business. If a penny stock takes on a massive lawsuit, for example, the shares could tank. That would represent risk to shareholders independent of how the overall stock markets are performing.
15 Competition in Penny Stocks
Some businesses have the deck stacked against them. The more current (and potential) competitors, the tougher the road will be for that particular stock.
Good analysis involves understanding the strength and weaknesses of other businesses operating in the space, barriers to entry to new competitors, and whether the total market (and the individual company's market share) is growing or shrinking.
16 Executive and Management Team
The Executive Team of any business is public knowledge. You know what else is public knowledge? Where those same execs worked previously.
It just takes a few quick Google searches, and you should be able to build a picture of how successful they were in their previous positions. Put on your detective hat and snoop.
Remember, in stocks just as in life, people will tend to do exactly what they have always done. Winners win. Losers... not so much.
17 Employee Pool
Some industries, especially those related to technology, tend to have very high costs and resource outlays to acquire and keep top talent. The bigger employee pools with significant numbers of potential workers are better for the business.
When any company has issues filling their headcount to the required levels, it can be a costly, disruptive situation. Even worse is when businesses in an industry are involved in employee poaching, luring, and brain theft (regardless of which side of that interaction they are on).
18 Legal Action and Intellectual Property (IP)
Many tiny companies cannot survive a significant legal challenge, or afford to defend themselves. Even when they are the instigator, they may be too tiny to launch and fund the necessary actions...
...that is, unless they have some pretty rock-solid patents and trademarks. In such an event, they typically walk away with some serious cash (usually through legal settlements rather than actual court decisions). However, win or lose, the process takes years, the outcome is uncertain, and until the very end there is a cloud over the stock. In other words, there is no winning any law suit for the shareholders.
Small stocks involved with legal battles, or those which are more likely to find themselves in the courts, should usually be avoided.
Part Two - Technical Analysis in Penny Stocks (TA)
Technical Analysis makes up about 10% of our Leeds Analysis review, and helps identify potential price movements with a high degree of reliability.
Keep in mind, TA is only accurate at certain levels of trading volume. Most TA with the majority of sub-$5 stocks is absolutely unreliable, even if a pattern appears to be forming.
Based on that truth, over the years we have identified a few TA patterns which can be trusted when the buying and selling activity in the shares in significant enough.
19 Consolidation and Shareholder Turnover
When a stock trades in a relatively flat range, for weeks on end, this can represent a turnover in the shareholder base. Frustrated stock owners from the previous years are selling, while that supply is being swallowed by new investors. This Yin - Yang activity keeps the trading range flat.
The thing is that newer shareholders are optimistic in the stock they just bought, and are less likely to sell any time soon. The shareholder base is turning over until a tipping point is reached, whereby the sellers dry up, or anyone who wanted to sell now has done so. This results in a refreshed base of shareholders looking for the stock to climb.
Often, when 20% to 55% of shares have changed hands in a tight range, over a few months, the next move for the investment will be higher.
20 Temporary Dips and Spikes
Since sub-$5 shares are thinly traded, even a small amount of buying or selling can really move the investment. Often the drop or spike is based on technical factors, and has nothing to do with the actual prospects of the business.
When a penny stock moves 20% higher or lower on very minimal trading volume, that price change often gets reversed within days, if not hours.
21 Permanent Dips and Spikes
Often an investment will make a significant move in price, but unlike a temporary dip or spike, there is a fundamental reason behind the price activity. For example, a stock releases their financial results which show that they are making way greater profits, and expect the trend to continue.
The shares may react by jumping 30%, but investors should not expect that move to reverse. Since the price jump had a basis in operations of the business, the new trading range may become permanent. Often very high trading volume will drive the point home.
22 Support and Resistance
Shares of a stock may have trouble breaking above a certain price (resistance) or buying activity increases at a specific price (support). With thinly-traded stocks, support and resistance levels often form at psychologically significant prices, such as $3.00, $1.25, or $0.50 (as opposed to $1.21, $2.87, or $0.36, for example).
By understanding when a stock trade is affected by support or resistance levels (or sometimes both at once), an investor can clarify advantageous price points to make their trades.
23 Topping and Bottoming
Speculative investments are usually driven by momentum, but that momentum (no matter how great) can run out of steam. When it does, the investment will often reverse what had been a major, long term move until that point.
Identifying topping and bottoming trend reversals can be incredibly lucrative, since you could be getting invested with a sub-$5 share right at the beginning of a long term move higher, or alternatively getting out of an investment just before it starts to slide significantly lower.
Tops and bottoms can be indicated by a slowing in the daily and weekly price movements (ie- up 8%, then 6%, then 3%, etc...). Daily trading volume will also drop off as a trend begins to turn.
For example, a stock may demonstrate that it will top out after a major, long term upward run by a daily slowing in the magnitude of the share's price increases, along with a significantly decreasing trading volume. The shares may then trade sideways for a few days, before taking a major fall.
24 Current Trend and Reversals
You have heard the stock market axiom, "the trend is your friend." These words are very true, in that probabilities show that any investment is more likely to continue further in the current direction than it is to move in a new direction.
If shares have been going higher, they will probably continue to do so. By identifying the current trend in the shares, you will know the probable future direction.
Of course, nothing can keep moving in the same direction forever. By isolating moments where a trend is about to shift to a different trend, investors can identify opportune purchase and sale prices for the shares.
Much like topping out and bottoming out patterns, trend reversals can be spotted by changes (decreases) in trading volume and momentum.
Part Three - Third Level Analysis in Penny Stocks[tm]
Third Level Analysis is all about recognizing the position of a business in their market, as well as understanding the place the company's products hold in the minds of the customer/prospect.
A highly-respected, trustworthy brand has tremendous advantages over some dishonest, unprofessional product or person. The consumer (that's you) will reach for the brand they trust, and which delivers on the promises it makes.
25 Brand Value Trends
Certain types of products are held in higher regard by consumers. Why else would anyone pay $12,000 for a purse, just because it had the right brand identified on its side? The purse owner wants others to see that she has an official Louis Vuitton, because she knows her friends understand how expensive it was.
Brands with "cache" often sell more, for higher prices, and with less conventional marketing costs. Consumers will reach for products that they trust or like, such as Red Bull energy drink, while passing on other brands such as Monster or Rock Star.
Every product has certain brand value built into its offerings. Identifying those which are getting stronger (such as with the Tesla electric vehicles, or Uber taxi service) or weaker (such as with Crocks footwear or Benetton fashions) will provide insight into the future of the penny stock in question.
26 Brand Awareness Trends
A strong, compelling brand becomes more relevant as more people become aware of it. The world's best brand might only have 100 people who know about it, while a terrible brand might not be able to do much even with millions of consumer eyeballs.
When it comes to penny stock investing, those companies with steady growth in awareness of their brand are very likely to enjoy increasing sales and a growing customer base. This typically leads to an increase in the share price of the underlying investment.
27 Connotations Among Prospects and Customers
When it comes to penny stocks, there are all sorts of negative connotations. (Most of them are justified unfortunately)! This makes business harder for honest players in the space.
With any business it is important to understand what the customers and prospects already believe about the product, and assess if the underlying company will be able to overcome the negative tide.
On the other hand, many products and services have positive connotations, which can act like the wind at the backs of the business, making their path easier. (Think charities for sick children).
28 Product Positioning
Every industry is saturated with competition nowadays. In fact, many tiny companies will only survive if their solution holds a place in the mind of the consumer.
For example, starting a mobile phone company would be foolish. However, starting a company whose mobile phones are made in America with 100% American workers may have a chance at success. Any prospective customer who wants an American-made phone, or wants to support domestic jobs, will buy the American one.
Anyone who could care less either way will buy an iPhone... but at least the "U.S. Phone" company had a chance.
29 Product Differentiation
What makes a product different from the competition? Being unique will go a long way toward success.
There are a lot of restaurants, but if one franchise uses only 100% organic, all local ingredients, or has only world-renowned chefs, they will have a greater chance of standing out. But that alone is not enough.
Strong product differentiation is important, but ONLY if the prospects and customers are aware of it. Finding good penny stocks is not about looking for those companies with unique selling propositions... It is about discovering those companies which are doing a great job of promoting their product or service differences.
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