Improving your chances of penny share success

Investing in small cap "Penny Shares" is an exciting and potentially very profitable way of playing the stock market. Every investor dreams of finding tomorrow's growth stars that have been overlooked by the rest of the market but are poised to soar.

With research and patience it's here that you might be able to find the companies that famous US fund manager Peter Lynch once described as "ten baggers". These shares are capable of making you ten times your money and more.

In recent years some of the best performances have come from previously little-known companies like recruitment firm Staffline, promotional products business 4imprint and food retail chain Crawshaw.

But beyond the excitement it is important to remember the risks. Penny shares can be difficult and expensive to buy and sell. They can also be in poor financial health and may even be de-listed from the market. Many of them fail to ever produce a return for the investors that back them.

Yet in the search for penny shares, there are strategies for achieving a far higher hit rate of separating the wheat from the chaff.

Diamonds in the rough

Small cap shares are generally found on indices like the AIM All-Share and the FTSE SmallCap. These both lost ground last year but have performed much better in 2015. AIM is up by 10.6% while the more resilient SmallCap has risen by 13.6%.

However, one group of shares has easily outstripped the market. In just over two years this group of stocks valued at between £1 million and £50 million has delivered an average return of 89%.

The performance was driven by the fact that these shares were all highly exposed to a set of characteristics that financial academics have long known drive stock market returns. In simple terms, the companies were good (they had financial quality), the shares were cheap (they were good value) and their share prices had been beating the market (they had strong momentum).

To get a snapshot of the sort of companies that are currently exposed to the same factors, Stockopedia created a screen for Interactive Investor. The list is sorted according to StockRank, which scores and ranks every company in the market based on the strength of its combined quality, value and momentum.

The list includes recruitment firm Empresaria, which recently reported that efforts to improve its operating efficiency were paying off and that it is planning further growth. It's followed by aviation services business Air Partner, which, like Empresaria, has seen a lift in its share price during 2015 as a result of rising sentiment about its prospects.

Recent half-year results from security company Newmark Security were well received and brokers have increased their earnings forecasts for the stock this year. Meanwhile Red24, which also works in security and risk management, has also been upgraded by analysts as a result of an improving outlook.

Elsewhere, water management company Hydro International has also wooed investors this year with ambitious plans to grow its already profitable business. Finally, Titon Holdings, which makes window and door fittings, is the smallest company here, with a market cap of just £8.8 million, but it nonetheless profitable and growing.

In the year to date, this portfolio of shares would have produced a return of 32.6%, versus 6.9% from the FTSE All-Share.

Trading pennies

It's vital to remember that small-cap penny shares come with a very substantial wealth warning. These investments are not for "widows and orphans" and should be regarded as very speculative. In the search for penny stock successes, evidence shows that focusing on the quality, value and momentum of these shares can help to avoid disasters. But given the unpredictable nature of these companies the key to success is likely to lie in broad diversification.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

● Interactive Investor readers can enjoy a two week free trial and £50 discount to Stockopedia using the coupon code iii014 - click here.

● To learn more about Ben Graham and his deep value investing strategies, you can download the free Stockopedia book, How to Make Money in Value Stocks.

It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"