Feeling lucky? The ultimate guide to penny shares

Penny shares will always remain popular. This is because, whatever the investment climate, penny shares offer the exciting promise of serious percentage returns over the short, medium and long term.

It is simple mathematics. If a stock valued at 1p moves to 5p, the return on the investment is 400 per cent. A £20,000 stake can be transformed into £100,000. You rarely get this level of promise or return from a fund manager or a FTSE stock.

The flipside, however, is equally daunting. You can lose everything by backing a minnow that has many business pretensions but very little else besides. As ever, there is a very fine line between success and failure.

Valuations matter

Making an accurate valuation call is something investors sometimes get wrong. As Neil Badger of small companies broker Seymour Pierce Ellis notes: 'Less experienced investors may see penny shares and just assume that they are cheap – but many [companies] still have high valuations.'

Put another way, a company with negligible revenue and a £5 million market capitalisation may be grossly overvalued, whether its shares are 2p each or 200p.

Investors also need to consider how and why a stock has come to have a penny share tag.

On the one hand you have young, tiny businesses that are trying to find their corporate feet – publisher Electric Word comes to mind. On the other there are ventures such as Clubhaus, which ran up huge debts it could not service.

Then there are the likes of Marconi and Telewest, which have had the status of penny share thrust upon them through their own spectacular failings. While it is true that riches would certainly arrive if either recovered even a third of its former value, neither looks cheap or safe.

Be wary of the spread

The other crucial (perhaps the most important) issue that investors need to take on board before delving into the penny stock game is the spread between the buying and selling price. This can be huge when measured as a percentage of the share price.

The largest we found was in mobile communications specialist Offshore Telecom, where the market buys at 0.25p a share and sells at 0.75p. This makes the 0.5p spread equal to the stock's mid-price. Huge spreads also exist in PC Medics and TheBiz.com, among others.

Experts agree that investors need to be very wary when faced with such vastly different prices. They must also bear in mind that, as with the spreads in all companies, the key influence is the market-makers, which have to make money one way or another.

Market-makers always defend their position in this game robustly. One City trader states: 'I think the problem is one of illiquidity, as much as anything. Take Offshore Telecom, for example – the shares hardly ever change hands.'

For those looking to hold for the medium term, spreads should not cause much of a problem. But, as an expert advised, 'There is no point in buying and selling penny shares quickly, as you've got no chance of moving through the spread in a day.'

Back potential

The consensus is that, when it comes to buying penny shares, the best strategy is to select young businesses with a strong central offering.

One such firm is Recycled Waste, which boasts a method of using microwave energy to shrink waste by about 80 per cent and create value-added by-products. Its prospects have been bolsted by government legislation on waste.

Another stock is Cytomyx. Since joining Aim in May 2001, Cytomyx has signed numerous agreements, the most significant of which will see it provide 250 full-length genes to German biotech M-phasys as part of its investigations into the production of functional cell membrane proteins.

Media rights group Maverick Entertainment also looks interesting. The company is best-known for owning the UK video and DVD rights to a series of 1980s cult carton series, including GI Joe, My Little Pony and Transformers. Maverick reported a £225,561 (£151,750) loss on £330,889 (£94,821) revenue for the year to December 2001. But because the first Transformers DVD was only launched at the end of 2001, this year's figures should be a lot better.

Longer term, Maverick has high hopes for Snailsbury Tales – a cartoon series it is producing for the BBC. The show is due to begin screening on the BBC's digital children's channel this summer, and should hit terrestrial screens by September. A seven-year deal has also been signed with Australian state broadcaster ABC.

In the mining and resources sector, mining finance groups African Gold and Tiger Resource Finance look to be the pick of the current crop.

Recovery plays

While all of the companies mentioned above started out as penny shares, many of the stocks featured in the table on pages 38-39 have seen their shares crash following poor performances.

Having got their houses back in order, several of these are intriguing recovery plays. Take sports and leisure equipment play Tandem, for instance. It dropped down from Full List to Aim in September 2000, having run up a £5.8 million loss the year before. It has since staged an impressive fight-back to post a £1.2 million (£777,000) profit from £32.6 million (£26.5 million) sales in the year to January.

Fellow retailer Victory has more to prove, although it is trudging towards profitability.

In 1999 and 2000 the company, which distributes Virgin-branded cosmetics, reported losses of more than £20 million. Victory subsequently dropped its poorly-performing clothing line and switched its attention to cosmetics. This decision now seems to be paying off. Victory is forecast to achieve breakeven for the year to March 2003.

In the support services sector, Protec could be worth a flutter. The company came to Aim in June 1996 as digital security venture IES but, after a series of poor performances, commercial and government-focused security systems provider SDA reversed into the company in March 2001. It has since worked on contracts as diverse as providing CCTV systems to the retail and transport sector and radar equipment to the Royal Brunei Navy.

When it published interims back in March, Protec warned that, on account of lengthening sales cycles, it would fail to meet expectations for the year to June. But while Ben Archer of house broker Teather & Greenwood now forecasts a £470,000 loss from £18 million sales for the period, he is looking for £1.2 million profit in 2003. Forecast earnings of 0.85p put the company on a forward p/e of just 4.4.

Shells and investment companies

Another strategy which those interested in penny shares can adopt is to look for cashshells and investment vehicles that are trading at a discount to assets and also boast strong management.

As of 31 December, former internet investment vehicle e-capital Investments had £18.2 million sitting in the bank. Assuming that the vast majority of this remains, its £12.1 million market capitalisation suggests the shares are well worth a gamble.

Unlike e-capital, Axiomlab has stuck to its guns and continues to invest in young technology firms. It has around £10 million in the bank, stakes in several businesses and is valued at just £5 million.

Legendary Investments, headed by Joe Bloggs' Shami Ahmed, could be worth a flutter – if for no other reason than its 18 per cent holding in impressive Ofex-traded retailer Legends Surf Shops.

On the pure cashshell front, there are opportunities among Aim's legion of failed internet businesses. Food delivery firm Room Service recently backed itself into erstwhile internet incubator Cube8, while ex-e-procurement business Buyers Guide was to have been the vehicle through which recent Aim newcomer Cobra Bio-Manufacturing came to market. Although the Cobra deal collapsed, leaving the company with 'significant' legal costs, Buyers Guide remains a possible reversal target. At 23 May, it had £3.8 million in the bank, against a valuation of £2.8 million.

Two other failed internet business-turned-cashshells that could be worth a look are BikeNet and Streetnames. The former has a market capitalisation of just £450,000 and around £700,000 of cash left. The latter is 75 per cent-owned by well-known investment duo Nick Leslau and Nigel Wray and their investment vehicle Prestbury. Plans for the business are not yet clear, but those prepared to back the reputations of a duo formerly known as 'The Glitter Twins' may just reap substantial rewards.