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Penny stocks are an attractive prospect for investors looking for high returns at a cheap price. But they also come with considerable risks, including low liquidity and even potential scams.
Here, I’m looking at ways to try and separate the winners from the duds using the popular UK-based mining company Helium One (LSE: HE1) as an example.
Check the financials
Small businesses are usually unprofitable for the first few years. That’s not necessarily a bad thing, so long as they exhibit signs of growth.
Potential investors should check the balance sheet to see where they’re headed. Hopefully they’ll be able to see:
- Growing revenues: a consistent upward trend in sales is a positive sign
- Strong cash flow: a company burning through cash too quickly may struggle to survive
- Manageable debt levels: excessive debt can be a major red flag
Helium One’s not profitable yet but recently received a mining license offer for its Rukwa project in Tanzania. This is a huge development for the company and, if approved, could help drive significant revenue down the line.
Examine the business model
Businesses with strong demand, a competitive edge and solid long-term prospects are more likely to succeed.
Helium’s a rare gas that’s in high demand and can’t be artificially synthesised. Should Helium One’s mining efforts pay off, it could enjoy high demand for years to come.
Assess management quality
Research the management team’s background. Larger companies are kept in check by their board members but smaller companies can be unpredictable. This is critical when assessing their prospects.
In February 2023, Helium One’s CEO stepped down unexpectedly, which isn’t a promising sign. However, he was quickly replaced with Lorna Blaisse, the company’s lead geologist with 19 years’ experience in exploration projects across Africa.
Look for market potential
A penny stock operating in a growing industry has a better chance of gaining traction. Sectors such as technology, biotech and renewable energy often offer promising opportunities.
Helium’s unique characteristics make it crucial in medical imaging, scientific research, space exploration and leak detection.
Still, there’s a risk that alternative gases like argon could replace some of its uses. So while it’s a growing industry, long-term demand isn’t guaranteed.
Watch out for red flags
Not all penny stocks are worth the risk. Avoid companies with frequent share dilution, overly promotional tactics and low trading volumes.
If a company constantly issues new shares, existing investors may suffer. Avoid companies that rely on hype rather than substance. If liquidity‘s low, it can be difficult to buy or sell shares at a fair price.
This is a key risk at Helium One, as it’s repeatedly diluted shareholders to raise capital. It now has almost 6bn shares in circulation from the original 497m — a 12-fold increase.
There’s a risk of further shareholder dilution if more cash is needed.
Assess institutional interest
If professional investors or major institutions are backing a penny stock, that’s usually a positive sign. Their due diligence can help validate the company’s potential.
According to reports, over 50% of Helium One shares are held by institutional investors such as abrdn, Barclays and Oberon Investments.
From the above examples, we can see that while Helium One’s a promising penny stock, it still faces considerable risks. However, should its mining license in Tanzania be approved, it’s certainly one to consider.
