How to Choose the WinnersUnderstanding Penny Stocks

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Leeds Analysis II - Fundamentals

Competitive Advantages

Some companies do not compete on a level playing field. These are the penny stocks that you should want to invest in. I am not referring to temporary advantages that can be easily replicated. Look for those corporations who have a claim to their advantage, and will be able to leverage it for years or decades.

For example, one of the penny stocks I once picked for my subscribers was Silverline Technologies (SLT), which was a programming company for high-end computer applications. Their competitive advantage was that they were based in India, and it was almost laughable how inexpensively they could produce a quality program when compared to their U.S. based counterparts. They had an office in the U.S., and they programmed mostly for major U.S. companies. Their work was as good, and in most cases better than their competition, and there was no way that the domestic American corporations could match their price.

What is a good sign: The advantage is sustainable and not easily replicated. (See my SLT example above).

What is a bad sign: Companies that are lacking in a competitive advantage that their competitors all share. For example, it would be a rough go of things if you were a publishing house, but you were not based in New York, where all your competitors, and all of the writer's agents gathered.

Low Debt Levels

I love when I see a company with no long term debt. Not only does it lend itself to the operational effectiveness of the business (in that they have not needed to borrow money), but the underlying company still has the option to take on loans in the future if required. They may decide to take on debt to acquire a rival, or to survive through an industry downturn. Companies that have already racked up significant long term debt do not have the same flexibility.

What is a good sign: No debt. Another good sign is companies that have been paying their debt down quarter over quarter. Generally this money to pay down their commitments is coming from revenues, but it can also come from other sources like the sale of assets, or subsequent stock offerings.

What is a bad sign: Increasing debt load. As well, if a company has to factor in major payments every quarter just to meet their interest requirements on the debt, it will endlessly hamper the company's earnings until they have negated the loan.

Insider Trading

This can be tremendously helpful in some situations. However, it is the most over-used and most misunderstood fundamental concept out there. While it is true that company directors often buy shares or sell shares based on their perception of the company's future, they just as often trade for other reasons, and it is impossible to tell which is which.

In addition, since insiders and company directors do not trade weekly or monthly, it is difficult in most cases to pick up an accurate reflection of their intent. Some CEOs will not make a transaction in their company's stock for years at a time.

Often, the amount of an insider sale is so minimal that it should be ignored. If a CFO sells 10,000 shares at $0.50 each, should traders panic and dump their holdings? I doubt it.

You would be amazed at how bad insiders are at predicting the future direction of share prices. They may be very good at developing strategic alliances, or promoting their new anti-cancer drug, but they do not necessarily know much about stock market investing. I have been around long enough to see insiders load up on shares right before a collapse, and sell holdings before a big run-up.

Having stated my position, I will say that monitoring insider trades can be helpful in certain circumstances, if taken into account with several other fundamental criteria described here. On its own, insider trading is the most useless research tool of all.

What is a good sign: Consistent purchases by several insiders and company directors. At very least, they are financially committed to help the shares increase in value, and have a personal financial stake.

What is a bad sign: Share 'fire-sales' with CEOs and directors dumping large lots. Besides the underlying panic about the future of the company, the high selling volume could drive prices lower.

Buy Back Plans

When a company commits to buying back shares, it is almost always a great thing for shareholders. What generally happens is that a company will use current funds to acquire a certain percentage of its shares on the open market. The shares will be bought over a specified time frame (usually a year) and once bought will be retired (meaning 'eliminated').

While this decreases the company's cash position (which is bad), it reduces the number of outstanding shares (which is good, because the percentage of the company each share owns is greater, thus each share is more valuable). It also provides buying pressure to the market, and states the belief that company directors feel their shares are undervalued at current levels.

In theory, as a shareholder you would want every share besides your own to be retired. Then you would own 100% of the company, certainly an improvement of the underlying value per share.

What is a good sign: Consistent buy back plans year after year, where the company continually gobbles up 5% or 10% of the outstanding shares.

What is a bad sign: Instead of buying shares back and retiring them, they are continually dumping new shares onto the market, by selling new public offerings to raise money. This is also known as share dilution.

Industry Conditions

The key underlying forces that drive a company's industry will also drive the company. If you invest in a gold mining corporation, swings in the price of gold will be as dramatic upon the penny stock shares as the company's own earnings and revenues.

What is a good sign: A hot sector that is lifting all the involved companies is always fun. What is better is predicting which sector will be hot before it takes off (and being correct).

In 2001 OPEC (Organization of Petroleum Exporting Countries, which include Iran, Iraq, Egypt, etc...), along with support from Russia and Mexico for the first time, stated that their intention was to keep the price of crude oil between $22 and $28 a barrel. They would ensure this through control of the global supply, meaning that production cuts and increases would be used to influence the prices.

Whenever the price fell very far below this level, I felt certain that OPEC would follow up at the next meeting with a supply cut. By featuring shares in oil exploration and recovery companies, I was able to help my subscribers get involved early.

Not only were the companies I liked trading at very inexpensive levels because of the low oil price, they were also still making money in the currently difficult market. Sure enough when the OPEC decision came through (you could set your watch to it), the oil sector would be given a boost. This gave the companies I had featured a primary pop in price. The companies would then get a secondary pop as the price of oil began to rise in response to the cuts, and those companies began boasting greater revenues and earnings.

What is a bad sign: Often it does not matter how well an individual company is doing if the entire sector is falling. Even a gold company that is making good money could see itself sinking as traders pull their cash out of the entire sector.

Institutional Holdings

Other companies, venture capitalists, and even investment institutions can own shares in a company. These 'institutional holdings' represent the percentage of shares of the underlying company that is being held by such organizations.

What is a good sign: Venture capitalists and investment houses feel strongly about the company's prospects and are holding shares for the long term, or are increasing their positions.

What is a bad sign: If a major institutional shareholder decides to liquidate a large position in the stock, it can send the equity into free fall. This may also reveal that they have seen something that they do not like, or are uncertain of the company's future.

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