Penny shares may be loosely categorized as growth,
recovery, shell and cyclical. There is some overlap.
Growth
Many growth companies will be high-tech, and tangible
assets may be thin on the ground. You should value
small growth companies using discounted cash flow
(DCF) analysis and, if they have earnings, the P/E
ratio or PEG and, if not, perhaps the price/sales
ratio (see Day 7). Do not expect dividends.
Since the bubble of soaring prices of internet stocks
burst in March 2000, some of the revenue-based valuation
methods (see Day 1) have all but disappeared. Real
option pricing puts a value on the company’s
flexibility to take appropriate actions in a variety
of scenarios and, as a valuation method, it survived
the dot com fallout. It is only as good as the information
fed into its models.
Biotechnology companies
Biotechnology companies are viewed as a high-risk,
high-reward alternative to pharmaceuticals. The UK
has 500 biotechnology companies and only a fraction
of the products under consideration gets from discovery
to marketing approval. The success rate improves once
products have cleared early hurdles. Pharmaceutical
companies may help to fund the product trials of their
smaller cousins.
The most usual way to value biotechnology companies
is through dis¬counted cashflow analysis (see
Day 7), or using the price/research ratio (share price
divided by Research and Development per share). In
addition, compare cash burn, which is cash spent,
with cash held, and watch how close key products are
to completion.
If a main product fails, the share price is likely
to plunge. In 1996, British Biotech’s shares
were 300p but they plummeted after the company’s
Marimistat cancer drug turned out to be ineffective.
By June 2000, the share price was 19.25p.
The investor risk is reduced if the company has a
pipeline of at least several products, including some
with a large market, although this also increases
the competition, as happened in HIV and cancer therapies.
For developments in the sector, visit the US sites
Biospace.com (www. biospace.com) and Recap.com (www.recap.com).
Recovery
Recovery stocks are former stock market darlings that
fell out of favour. The company will have survived
only because it restructured its business, perhaps
lopping off unprofitable divisions or making a synergistic
acquisition.
There is some hope that recovery stocks may return
to glory and investor sentiment can be strong. The
share price may double in value within a week, or
in a few months, but on setbacks it may fall as hard.
Compare the current price with the high and low over
the past 12 months. A share may not repeat the old
price patterns, but such data still tells you something.
Look for a trading prompt. An upgrade in analysts’
consensus forecasts or directors’ buying can
be a green light. A new broom as chief executive can
work wonders. But some companies have problems that
are not resolvable by direct action, and you should
steer clear.
Shell
A shell company is a quoted company that does not
trade. It may be dirty or clean. A dirty shell is
an ex-operating business. It may have transferred
its business to a subsidiary or to a parent, and be
a form of recovery situation (see above). A clean
shell is not so encumbered and can be preferable from
an investment perspective. It will have been formed
to seek acquisitions. The usual way is through a reverse
takeover, where the company taken over seizes control.
To reverse into a shell can be a cheap and convenient
way for an unquoted company with a limited track record
to obtain a Main Market or AIM quotation. If it happens,
the shares will be suspended for about six weeks,
and will then be quoted again, perhaps at a higher
price.
The garden is not always so rosy. Clean shells have
been known to sell shares to investors on acquisition
plans that have come to nothing. You may prefer to
wait until a deal has been announced before you invest
your money.
New disclosure rules for AIM stocks have made it less
risky to invest in shells. If an investing company
was admitted to the AIM before 1 April 2005 and raised
less than £3 million at admission, it had until
1 April 2006 either to make an acquisition through
a reverse takeover or to satisfy the London Stock
Exchange it had carried out its investing strategy.
Companies that failed the criteria were suspended
from the AIM with an ultimate threat of removal from
the market.
The minimum £3 million of investment in shells
means that institutional investors are involved enough
to provide essential stops and checks, according to
the London Stock Exchange. The dirty shells must obtain
shareholder agreement at annual general meetings to
extend their lifespan by 12 months. A company that
fails to obtain this agreement will be dissolved.
Cyclical
Cyclical stocks rise and fall with the business cycle.
The businesses include, among others, house-building,
construction, steel, car manufacturing and distribution,
and resources. You should buy near the bottom of the
cycle, when, for example, a good house builder is
buying land cheap and selling it at high margins before
competition starts muscling in.
The better known the company, the stronger its backing
and the more easily it can exploit the bottom of the
cycle. The less well-known companies often have bigger
growth potential, but the investment risk is higher.
Resource companies are exposed to the crude oil price,
which is subject to political and economic risk. A
majority of AIM companies are in the sector. Unlike
the oil majors such as BP and Shell, the tiddlers
do not have downstream activities such as refining
and petrol stations to generate income if the price
of crude oil declines.
Invest in cyclical survivors. If turnover has stayed
steady in a recession, it is a good sign and some
decline in profits may easily be reversible, perhaps
through a cost-cutting programme. In a property company,
asset backing per share is ideally higher than the
share price. This provides support in lean times and,
if the company is wound up, the liquidator will pay
shareholders in proportion to the company’s
assets. It also attracts predators. |
