Investing in Micro Cap / Penny Stocks - NWT

What is a micro cap or penny stock?

Before I go on to give an example of how I have managed to trade the 'occasional' micro cap,  I want to first explain what I think a micro cap is.

Stockopedia have their own definitions of market capitalisation bands for UK Stocks here.  I hold the view that the term 'micro cap' is arguably any stock with a market capitalisation under £15m.   I tend to also think of a 'penny stock' as a stock with a share price below 50p although again arguably some sources  define 'penny stocks'  from 300p or below. 

But whatever definition is used most penny stocks have the same characteristics.   They are usually illiquid, speculative, high risk and listed on the LSE junior market the Alternative Investment Market (AIM).  They list on AIM where regulation is lighter than the main market.   Many of these stocks require fund raising, usually through the issue of more shares (rights issues which in turn dilute the share price).

The answer is simple.   The thought of doubling, tripling (or more) your profits. A huge number of private investors love them.  They can be exciting, fun and the most talked about stocks on bulletin boards.  Terms Like 'multi bagger' and 'strong buy' are often used by posters to entice more private investors into buying this 'low risk' stock.   The directors of the company sometimes put out positive spin on their trading statements.  Things like 'Our future is bright.  Sales and profits expect to increase exponentially over the years'.  'We expect our share price to double in the next few months.'    All these factors drive many private investors into a momentum of false optimism  You would be foolish not to buy in and miss out on these massive gains huh?   

Unfortunately for most private investors the reality is somewhat different from the dream.

As a subscriber to Stockopedia I have access to some pretty nifty and effective portfolio tools.  One is the bubble chart.   Based on the StockRanks system it can give a clear overview of how risky a basket of stocks in a portfolio can be.   Is the majority of the stocks 'expensive, junk, lagging ' or are they 'Good, Cheap, and leading on momentum'.

I know the staff at Stockopedia had done an article on the most discussed stocks, but briefly I have done a bubble chart based on a small number of the most talked about stocks on the bulletin boards.  All these have been volatile, failed to perform or have spiked high in price just to fall again (pump and dump).   Some penny stocks may multi bag that has low ratings but in general they fail to perform.

Personally I think Investing in penny stocks have the same traits as investing in any other stocks.  There are no 'safe' stocks to invest in.  It is about reducing risk.  An investor should have a proven and successful system in place for stock selection.  A checklist of easily understandable criteria and financial ratios that when applied should narrow the stock selection down to some good quality, cheap stocks.  A penny stock that passes my initial screening criteria just requires a bit more rigid discipline, patience and a clear exit strategy if things go wrong. My normal criteria for stock selection is based on  The Naked Trader set of rules modified a little to better suite my own needs.

Mandatory Criteria

1. Revenues are increasing and forecasted to increase
2. Profits are increasing and forecasted to increase and within the 15x multiple to Market capitalisation. 
3. Low Net Debt, preferably Net Cash
4. Earnings increasing and forecasted to increase
5. Net Cash Flow is positive (Net Cash In Flow)
6. Positive trading statements and outlook

Nice to have (mandatory in small and micro caps) 

1. Free Cash Flow Per Share greater than Earnings Per Share
2. High Stockopedia StockRanks (Rank 70 and above)
3. Low PE (below 15)

So when applying the above criteria then I have a good chance of picking a good quality, cheap stock.  The difference in picking a penny stock is that it must pass ALL the above criteria including the 'nice to have'     Finally applying a wide Stop Loss is also mandatory when investing in a penny stock.

Newmark Security is a technology company based in the UK.  It designs, manufactures and splays products and services for the security of assets and personnel.

NWT came to my attention in October 2014 when i was screening high stock ranks for my new 20K Stock Ranks Portfolio.   The portfolio was created as a mechanical system based on Stock Ranks and NWT was added into it.  

Last October the share price was 2.14p and had a Market Cap of just under £10m.  On the three year chart the price had risen slowly from 0.5p to 2.0p   The shares was illiquid and no one was talking about NWT on the bulletin boards.  It all seemed so boring and dull!  

However after briefly reading the past few trading statements to get a feel of  stocks history I felt their was something 'special' in this penny stock so I went ahead to apply my usual criteria with possibility of adding this into my normal portfolio.

1. Revenues forecasted to increase 4%  - Pass
2. Profits forecasted to increase by 74%  - Pass (High Pass)
3. Net Cash of £2.75m - Pass and no sign of fund raising excellent!
4. Earnings forecasted to increase by 24% - Pass
5. Positive Cash Flow of £2.13m - Pass
6. FCF per share was 0.36p double the EPS of 0.17  - Pass (High Pass)
7. The StockRank was 98 - Pass
8. PE was around 7 - Pass

So all of the criteria passed including the 'Nice to Have' which as highlighted is mandatory criteria for penny stocks.  The Outlook statement from the Final results 2014 was generally positive as shown below.  There was some caution on revenue however forecasts were still showing growth.   

This was the type of penny stock that I was after that had a very good chance of giving me positive returns for my investment and as such I bought in at 2.14p.   I placed a wide stop loss at 1.5p.

Now was time for the waiting game... but I didn't have to wait that long..

On the 30th January 2015 the Interim results were published.   Revenues increasing but slowing but still ahead of previous year, profits increasing, earnings increasing, outlook statement positive..

So the price from January 2015 to March increased to 3p.  A wonderful increase and keeping my stop loss at 1.5p I wanted to allow the share price more room to breath.   

By the beginning of August 2015 the price has spiked up to 4.65p  I was around 120% paper profit and delighted. 

The Final Results RNS issued 10th August 2015 and immediate sell

The headline figures were fantastic.   Revenue increased 19%, Pre Tax Profits increased by 150%, Net cash Increased to £3.95m, increased dividends, Cash Flow still positive and still ahead of earnings.  PE of 7.  It all read so good.

But then we come down to the Chairmans Statement and having already warned on a slow down on revenues was the following warning on profits going forward.

Immediately at least two of my criteria are broken.  Profits will be decreasing and the Outlook is negative based on this sentence.

In my experience penny stocks suffer as soon as there is anything negative reported and can take a long time possibly years to recover.  My exit plan was clear..  SELL immediately on opening if my Stop Loss isn't hit first.

I sold out at 08:10 am when the price had fallen to 4.2p  I was happy and I returned around 96% from my original investment.  The price through the day has continued to fall by 30% and as of writing sits at 3.4p.   

By selling out immediately on negative news I have protected my gains on this penny share as best as I can.   If I hesitated or waited a bit longer then I would have lost 30% of my gains.   I doubt now the share price will climb for the foreseeable future (but I may be wrong).  It doesn't matter as in 9 months I have made good profit from this penny stock and now I can move on to look for further opportunities else where.

The right hand side of the chart shows the spike up and down common of penny stocks leading up to and on results day.

Penny Stocks can be part of a diversified portfolio and as I have shown in NWT there is a successful ways to make money from them.  It is not easy to find a good quality, cheap, penny stock.  The bulletin boards attracts most private investors to the junk, story stocks.  High risk pump and dump that carry more results of failure than successes.   

Using Stockopedia StockRanks is a good start in finding less risky choices in these type of stocks, while discipline, patience, not exposing too much of your portfolio to the one stock and having a good exit strategy will all work in your favour.

It is not often I invest in penny stocks but on rare occasions there comes across a stock that fits all my strict criteria and has a positive outlook.  I will chose to put in a small amount of my cash, and place a stop loss in case it all goes wrong.   That way I can sleep at nights and have the patience to see how it all works out.  If something unexpected happens then I can sell straight away and move on.

NWT was an unemotional investment.  It's all about numbers.  It no longer fits my criteria and now I move on to my next stock.