How to Intelligently Trade Penny Stocks

First off, if you are going to "play" the Penny stocks, you should be trading the majority of them and not investing in them. You'll understand why shortly.

Penny stocks are normally those that have a share price of $5 or less, with many being under a penny. Those stocks that sell for less than a penny are called "subbers", as they are a sub-penny in value. Some actually trade in the hundredths of a cent.

The majority of the pennies and subbers trade don't trade on the higher exchanges, such as the NASDAQ or AMEX, but rather on the Pink Sheets or the Over the Counter Bulletin Board (OTCBB). This is due to them not meeting the minimum requirements of the higher exchanges, primarily because they are emerging, small companies in the development stage.

Before getting into the actual nitty gritty of the trades, you will need to meet your own requirements before trading:

- Most importantly, never trade with money you can't afford to lose! Read that again. Too many people take money out of savings, their paychecks, etc., that is needed for their daily expenses. The worst case is taking out a loan to "invest in a sure winner". Greed kills. Mortgage or rent goes unpaid, marriages suffer, etc.

- Find a broker that has online trading AND also will allow you to trade in penny stocks on the Pinks and OTCBB. Not all do, and you don't want to take the time to set up an account and find out later that you can't trade the penny stocks. Check first before signing up!

- You will eventually migrate to a trading forum board on the Internet and discover all sorts of great picks - not! The message boards are dangerous to your trading account for a variety of reasons. More to come on this below.

- Learn this term and apply it every time you think you want to buy a certain stock: Due Diligence, or DD. This involves researching everything you can find on the stock, and only factual, verifiable information. Some of the resources are the company's own web site, official press releases (PRs), web sites such as Yahoo Financial, The Pink Sheets, InfoQuotes, etc. One thing that is NOT DD is getting info from the message boards, unless there is a verifiable source.

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We've all heard the stories of someone who has made a fortune by trading hot penny stocks. Is it that easy? Can you really make a lot of money by investing in small caps? The real answer is yes and no. While you can make better returns than investing in large caps, you are also putting more money at risk. That risk may lead to potentially to large losses.

The term penny stocks generally refers to any stocks that trade outside the major stock exchanges and is taken as ‘deprecatory’. The major stock exchanges would include: NASDAQ, AMEX, or NYSE. The term Penny stock is also often used interchangeably with small caps and nano caps. The title of penny stock however should be determined by the share price rather than the listing service or market capitalization.

The question that you need to ask is how much risk do you want to put your portfolio at? Our suggestion is to start by investing no more than 10% of your total portfolio value. Our second suggestion, is to follow the tips we have put together.

The more you increase your risk, the higher the potential for failure, but the higher the potential for reward.If you want free penny stock picks, you'll want to sign up for the smallcap 360 newsletter. Our free newsletter features penny stocks listed on the TSX Venture, OTCBB and Pink Sheets boards.

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If you’re seriously evaluating your exit strategy, managing the process through a professional may help. Having a third party involved to represent your firm often lends credence by serving as an indication that you're serious about selling.

Depending on your size, you may choose a business brokerage or an investment bank. Both help you accurately gauge market interest, bring potential buyers to the table and create a bidding process to get you the best offer. In addition, such an intermediary will be able to guide you through the process – from signing a nondisclosure agreement (NDA) with a prospective buyer to help in structuring a transaction.

Or, you can sell the business yourself. Whether or not you use an intermediary, arm yourself with a business valuation and good advisors. Here are 10 ways to better prepare for the sale.

1.	Get Your Books in Order: Financial statements are the best indicator of the future performance of a business. Buyers evaluating your company will generally require at least three years' worth of financial information. The more formal your statements (accountant-reviewed or -prepared vs. internally generated), the better the impression you'll make and the easier the due diligence for a buyer. Audited financial statements are ideal. Having a top notch business plan to accompany your financials will increase your credibility with potential buyers.
2.	Grow Your Business to Sell It: It is always easier to sell a business whose sales are growing than one in a downward trend or even flat. Buyers generally want to invest in a company that will provide them with a good return, so they’re willing to pay more for a business that has a positive trend and outlook. If the company's future success appears to be threatened (a competitor entering the market, technological advances outdating company products, etc.), the value of the business will be affected. The marketability of the firm may decline as well.
3.	Evaluate the Impact of External Factors: The climate in which a business operates can also affect its valuation and marketability. An overall economic downturn can result in the tightening of corporate belts and a reduction in acquisition activity. In the same manner, a decline within a specific industry or geographic region can also prompt a diminished appetite for private-company acquisitions in those areas. Additionally, a decrease in a public company’s price/earnings ratios tends to produce a corresponding "trickle down" effect for the multiples paid for private companies.
4.	Valuing Your Business – Using Multiples: There is an abundance of available data on common industry "multiples" that can be used to estimate a business's value. Over time, valuation experts and investment bankers have observed trends in the selling price of businesses. Multiples are simply a summary version of these trends. They are industry-specific and generally used for smaller businesses. However, while multiples may be useful in providing an immediate ballpark of a business's value, they do not substitute for a comprehensive valuation analysis.
5.	Valuing Your Business – Taking Intangible Assets Into Account: When pricing your business for sale, intangible assets – such as people, knowledge and market position – can be even more important than tangible property. Customer awareness that underpins a prominent position within the market is a key ingredient in many companies’ success. A strong brand and a loyal customer base can be distinct assets. Other distinct intangible assets include copyrights or trademarks that let a business sell its products for a higher price or in greater quantity than its competition; proprietary mailing lists of customers or prospects; long-term contracts; and franchises with long track records and well-recognized names.
6.	Get a Business Valuation:: A professional valuation will give you a basis for gauging offers. It will give you an idea of what you can expect to net from the sale. It will also tell you your company's market position, financial situation, strengths and weaknesses (which you can address prior to putting it on the market). Valuations can be obtained from a number of sources, ranging from local accounting firms to business brokers and investment banking firms. As a rule, you should make sure the company performing your valuation has access to the most current national data regarding privately held transactions in your industry. Experience in selling firms of your type is obviously helpful as well.
7.	Maximize Your Price: Concentrate on Core Competency: A company with a strong focus around a core business generally tends to be more appealing to a buyer than a company going many different directions. Make sure that the focus of all members of the management team is aligned in this direction and that your firm’s products and services add to the value of your core business. Reduce Customer Concentration: Many small businesses can't help but have a handful of customers who generate a large percentage of the company's revenues. In general, a buyer will carefully review any client relationship that comprises more than 10% of revenues. Any efforts to reduce the level of customer concentration prior to a sale will be helpful in increasing the reliability of the firm's future revenue stream and will help to augment the firm's value. Industry Concentration: Specialization can give a company a competitive advantage in winning contracts through industry expertise; it can also force companies to take on risk due to lack of diversity. If an industry suffers a cyclical downturn, a company that has the preponderance of its customer base within that industry may be affected as well. There are exceptions, but industry concentration is usually viewed as undesirable.
8.	Know Your Buyer: Financial buyers make up an enormous segment of the market. They look for businesses they can buy using debt financing for 50% to 75% of the price. They’re also looking for sufficient cash flow to service that debt. With few exceptions, they value a business by using a multiple of four to six times earnings before interest and taxes (after making adjustments for expenses that would not continue for a new owner). They deduct from the price any interest-bearing debt they will assume. There are disadvantages to selling to a financial buyer: There are no synergies such as access to a larger sales force, or complementary activities in production, engineering, or any other part of the business. Furthermore, there are pressures to increase the cash flow because of the added debt. Financial buyers are in business to make deals, so they often leave day-to-day operations unchanged. But they buy with a view to selling, which could disrupt your business life a second time. Strategic buyers expect synergies with their other holdings. They can afford to pay a premium, but they may not need to because they know the market. Buyers offering premium prices are in short supply. The best match sometimes comes about when they seek you out after having determined that your business fits their plans. Strategic buyers may diminish your role, however, and their goals may differ from yours.
9.	Plan for Management Succession: If you're absolutely vital to your business, who will a buyer be able to turn to for help running things after you leave? Efforts should be made to gradually delegate key responsibilities (primarily those related to customer relationships and other direct ties to revenue generation) to various members of the senior management team. A buyer's primary concern is that the business can operate successfully in the absence of the current executive.
10.	Get Your Ducks in Row: Get an advisory team in place that includes an attorney and accountant who are proficient in mergers and acquisitions. Organize your legal paperwork. Many privately held companies conduct business on an informal, or "handshake," basis with customers and vendors. Informal agreements, however, can result in a discount to value – particularly when they are key to the company's success. Formal agreements can ensure the continuity of key relationships, giving a buyer peace of mind that the company's customer and supplier relationships (and therefore cash flow) are secure. In addition, review your incorporation papers, permits, licensing agreements and leases. Make sure you have them readily available, current and in order. Make a good first impression. Insure that when prospective buyers visit, they see an orderly operation instead of one that is chaotic. And no matter what, keep your eye on the ball. Don't let your business performance decline because you're too focused on the sale. This will only give buyers additional negotiating power to lower their offers.