This article was originally published on August 13, 2021, as part of Tom Yeung’s Moonshot Investor series. Investors interested in finding stocks with 100x potential or more can subscribe to Tom’s mailing list here.
If you had to win a game of chess, would you rather play against a novice or against grandmaster Garry Kasparov?
If money were involved, I’d rather wager against someone who’s never played before. Anyone else and my non-existent chess skills would soon have me living on the streets. Perhaps I can convince you to play poker or tic-tac-toe instead?
The same holds true for stocks. If you want to beat the market, then you’re better off playing against clueless day-traders than billion-dollar quant funds.
That’s where penny stocks come in. Thomson Reuters reports that almost one-third of all U.S. stocks trade for less than $5, and most of these companies are too small for Wall Street to buy. If you run a $10 billion hedge fund, then playing with $100 million stocks looks a lot like a whale trying to squeeze into a fishbowl.
That’s why top stock pickers like my InvestorPlace colleague Luke Lango tend to focus on smaller companies when seeking Moonshots. His No. 1 electric vehicle pick for instance, amazingly trades for just $2. And if you want to find profit-producing penny stocks for yourself, then the Golden Rule Strategy might be right for you.
The Golden Rule of Penny Stock Investing
Let’s face it: penny stock investing is risky. According to academic studies, 60% of bankrupt companies end up leaving investors with zero. And of that 40% that do survive, fewer than a quarter rewards their investors with gains.
Picking winners however, is easier than you might think. That’s because penny and small-cap stocks are rife with various mispricings and inefficiencies. Imagine a chess tournament where no professional grandmaster was allowed to play. That’s pretty much like what OTC markets look like (extending the previous metaphor, it’s a goldfish bowl free of whales).
To succeed in penny stocks, we’ll combine momentum and qualitative-based strategies to create my Golden Rule of Penny Stock Investing.
Strategy No. 1: The Momentum Play
Regular readers would know my Momentum Master strategy by now: get in on rising momentum, and get out the moment the tide turns.
Meanwhile, novice penny stock investors will often ignore the warning signs of the typical penny stock con. It goes like this:
- The Setup. A stock trades sideways for months. Financial filings are optional.
- The Big Con. The company issues a flashy press release promising something solar, marijuana, blockchain or [insert your favorite hype here], sending the stock up 200%.
- Cash Out. Novice buyers rush in after seeing the price action from the press release. But it’s too late — sellers are already unloading their stock, leaving incoming buyers holding the bag.
These stocks are usually an alphabet soup of unrecognizable names — HealthLynked (OTCMKTS:HLYK), Transphorm (OTCMKTS:TGAN), and so on.
Consider Viper Networks (OTCMKTS:VPER), an over-the-counter stock trading at near-zero valuations for a decade. In early February, shares of the LED/fintech/renewables company inexplicably ticked upwards. By the time the firm released its press release several days later, shares had already risen from 0.01 cents to 6 cents, an almost 60,000% return.
I suspect insiders were the ones front-running the market. Because the moment the flashy press release hit markets, the stock tumbled back to near-zero.
So rather than waiting around for the news, investors relying solely on Strategy No. 1 need to use Momentum Master to pick out insider buying before press releases get sent out.
Strategy No. 2: The Quality Play
On the other hand, longer-term investors usually consider the quality and potential of a penny stock’s business. It’s what my colleagues — Joanna Makris, Luke Lango and others — do at InvestorPlace.com on a daily basis.
Consider Hertz (OTCMKTS:HTZZ), a stock that rose another 250% after I wrote about how the bankrupt rental car company could become the top penny stock of 2021.
“Hertz’s equity value might be worth anywhere between $800 million to $3 billion,” I wrote back in May. “Strangely enough, the longer Hertz spends in bankruptcy court, the better its chance of survival.”
Lenders finally agreed to a $1 billion valuation. And by the time Hertz re-listed as HTZZ a month later? Shares were worth over $2.3 billion, a 700% return. (Traditional valuation methods do work!)
However, this strategy could conversely leave you sitting on duds for decades. To avoid stagnation, we need something to bring the two strategies together.
Combining Momentum and Quality: The Golden Rule Strategy for Penny Stocks
Momentum. Quality. Cheapness. All these come together to form my Golden Rule Strategy:
To succeed in penny stocks, buy rising stocks with recognizable businesses and reasonable underlying brand value.
You can frame that on your wall. If you ever see me make a big bet on a penny stock, you can be sure the company fits that criteria.
Not only would this strategy have caught GameStop (NYSE:GME) in 2020, before Reddit pumped it to $480. It would also have picked winners like Bowflex-maker Nautilus (NYSE:NLS) and American icon Tupperware (NYSE:TUP) early on, while avoiding a whole host of duds along the way.
Notice how all of these winners are household names? The golden rule can be paraphrased as “does your next-door neighbor know the name of this rising stock?” If they do, that’s a good sign. But the moment you see their eyes glaze over at yet another unrecognizable ticker, it’s better to tread carefully.
Putting the Golden Rule to Work
I could keep giving you examples of past wins. But I know what you really want. So let’s put the theory to work. Today, we’ll take a look at two penny stocks that fit the Golden Rule Strategy: Gannett (NYSE:GCI) and Innoviz Technologies (NASDAQ:INVZ).
You’ve almost certainly heard of USA Today, the newspaper that seems to show up everywhere you look.
What you might not know is that its parent company Gannett is a penny stock company that also owns 252 other dailies, 308 weeklies, 375 local news websites and 100 international publications. We’re talking about everything from The El Paso Times to South Dakota’s Farm Forum.
That gives GCI the quality elements I look for — strong brands with plenty of local support and a stream of predictable revenues. Even if the firm isn’t profitable (and seems to be on the wrong side of Eric Fry’s Technochasm), its cheap valuation means that a private buyer could swoop in at a hefty premium — similar to what happened with Tribune Publishing back in February.
Momentum is also strong: GCI is up 100% year-to-date. Investors seem to be realizing that quality local content isn’t going away anytime soon.
Finally, GCI is also relatively cheap. Its $6 price tag represents a 0.13x price-to-sales ratio that should make value-minded investor rub their hands with glee.
Innoviz Technologies (INVZ)
Credit for this pick goes to my InvestorPlace colleague Joanna Makris.
“There are two very simple reasons to like Innoviz: technology and economics,” Ms. Makris wrote in her sweeping analysis of the autonomous vehicle industry. “The self-driving space is clearly filled with promise… You can buy INVZ now, as the stock isn’t overstretched, and wait to buy the others on (inevitable) blow-ups.”
At the time however, neither of us were sold on going long-only. Momentum was pointing in the wrong direction, and the Golden Rule Strategy wouldn’t allow buying a stock that was down 20% in the past-5 months. INVZ would continue falling another 20% after that.
At the time, we both used strategies to address that risk. Ms. Makris used a long-short strategy with Tusimple (NASDAQ:TSP) to lock in 42% returns, while I recommended two long-dated INVZ options (a volatility play) that are now up 20% and 100% respectively.
But following INVZ’s 20% gain in August, the Golden Rule Strategy suggests it’s time to jump in on the stock itself. The company had the potential, and now Innoviz has the momentum.
And what about Innoviz’s recognizability? Though your neighbors might not know INVZ, everyone in the automotive industry does. That’s because Innoviz makes up one of the big three lidar developers — the “eyes” of self-driving cars that let autonomous vehicles see the world around them. And because an early breakthrough could still propel any lidar player to the top of the charts, INVZ is the cheapest, highest-potential company that could soon be a household name.
What’s Your Batting Average for Stock Picks?
When it comes to picking stocks, most investors intuitively aim for a >50% batting average. If more than half of your stocks go up, common thinking goes, then surely you’re making money.
Meanwhile, experienced investors know that batting averages only make sense in the context of payoffs. If each win grants you 100x returns, you can afford a batting average as low as 2% and still double your money even if the other 98% go to zero. Meanwhile, those holding losers with serious downside will need a far higher batting average to offset their losses.
My Golden Rule Strategy for penny stocks sidesteps the mess. This tactic aims for high expected returns while maintaining a relatively high batting average by choosing firms with reasonable fundamentals.
The catch of course is that great deals don’t come around often. It can take a special set of circumstances — pandemics, financial crisis, fraud or bankruptcies — to send high-quality stocks into OTC territory.
That means it pays to be patient. Because when these easy wins do finally come around, they’re opportunities that shouldn’t be missed.
On the original date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.