When it comes to equities, there are few riskier investments than penny stocks. These stocks, which trade under $1 per share, are usually priced that low for a good reason. For example, a penny stock could belong to a once-thriving company that is now on the brink of bankruptcy, has had to delist from the larger exchanges and is now trading on over-the-counter (OTC) boards. Or it could be that a company's only just getting underway, and so it has scant market history and hasn't yet met the criteria to be listed on a major exchange.

Whatever the case, penny stocks are volatile and risky by nature (with companies going bankrupt a routine affair) and they're especially susceptible to price manipulation. (See also: The Lowdown On Penny Stocks.) Once in a while, however, a penny stock will greatly reward the risk-hungry investor. If you had bought shares in the Monster Beverage Corporation (MNST) in 1996, when it was trading at $.04 a share, you would be a happy investor today: Monster was trading at $135 per share before the market correction in late August 2015. So if you're intrigued by the potential to find such exponential gains, it could be worth diving into the murky waters of penny stocks.

Check the Fundamentals

As always, fundamentals come first (for more, read: Fundamental Analysis: Introduction). Investors should conduct thorough due diligence before taking chances on any penny stock. For example, it might have looked like a good bet to invest in the ailing Walter Energy Co. After all, Walter Energy had traded as high as $143.76 a share in 2011. But those who bought Walter Energy shares when they'd fallen to $0.16 still would have been burned, however, as the company soon declared bankruptcy. On the other hand, an investment in Inovio Inc. (INO), which was trading at $0.68 a share in 2008, would have paid off handsomely: in late August 2015, Inovio was trading at $7.04.

The stark contrast between these two stocks lies in company fundamentals. Walter was an established company in metallurgical coal, an aging sector prey to cyclical demand and political pressures. When world leaders made commitments to lowering greenhouse emissions, this put more downward pressure on Walter Energy, which already was reeling from a worldwide coal supply glut and slowing demand from China. Walter, which currently trades on the over-the-counter boards, vows to emerge debt-free by February 2016 (by restructuring its debt into equity), but with coal prices having fallen 66% or more (from over $300 per ton to $100 per ton today), and with further declines in global demand expected, Walter’s case for a comeback is dicey. By contrast, Inovio is a speculative biotechnology play with strong partnerships in its cancer vaccine portfolio, which offers strong buyout potential.

So when researching penny stocks, you should carefully weigh any potential gains versus fundamental factors underlying the company: its debt, cash flow, buyout potential, Porter’s Five Forces of Competition ad patents/ pipeline compared to its competitors, among others. You should have the complete picture as to why the stock's trading at its current price before you even think of buying it.

Industry Life-Cycle Analysis

Along with analyzing a company’s balance sheets, the prospective penny stock millionaire should look do an industry life-cycle analysis. (For more, read: Life-Cycle Analysis: The Industry Life-Cycle.) Some penny stock companies are in a sector still in its “pioneering phase." This initial phase is characterized by the presence of a large number of small-sized competitors in the space, novel products and concepts and low customer demand for the products. Because this period is marked by a slew of start-up firms (particularly in tech or biotech), all of which have high costs and little-to-no-sales to date, most of these companies will trade at very low prices owing to their speculative nature. Following this initial phase, however, is the “growth phase," in which many of these companies gain greater market attention and thus their sales and demand skyrocket.

The perfect example is the tech boom (and crunch) of the late 1990s. Many tech startups started life as penny stocks and then experienced astronomical gains in their market caps and valuations (seemingly overnight), as investors snatched up anything related to the then-novel concept of the Internet.

Penny Stock Industries

Industries that offer binary outcomes for most of its companies will unsurprisingly contain a plethora of penny stocks. Binary outcomes, or “make or break” speculative plays, are found predominantly in biotech or resource sectors. In fact, the Canadian Venture Exchange (now TSX Venture) was the home of many resource-based penny stocks that took off during the commodity boom of the 2000s. The party has now ended, according to mining.com: of the 2,340 companies listed on the TSX Venture, 1,400 were junior mining companies and 500 of those were considered to be in a “zombie” state: meaning, they had an overwhelming amount of debt, no profits, and filed paperwork on the exchange for the sole purpose of remaining listed.

However, once in a while, a junior miner comes along that strikes it rich: between 2008 and 2010, Stornoway Diamonds (SWY.TO) spiked from lows of $0.12 a share to almost $3. And Rubicon Minerals (RBY) went from  $0.70 to highs of over $4.00 a share in roughly the same time frame. These junior miners benefited not only from a favorable macro environment for commodities but also good fortune and fundamentals. They had politically stable exploration areas and excellent grades. 

Sound Management

If in real estate, it’s all about “location, location, location," when it comes to penny stocks, it’s about “management, management, management." Sound management can turn around a struggling firm and launch a startup to new heights. More importantly, experienced and ethical management that have a vested interest in the company via share ownership can provide investors with a sense of security.

Of course, superstar managers aren't often found working for penny stock companies, but there are a few examples. Take Concur Technologies (CNQR), which bounced back from its post-tech bubble price of $0.31 a share to get bought out last year at $129 per share, or $8.3 billion. This remarkable comeback is owed to many factors, but one that stood out was the strong vested interest of President and CEO Rajeev Singh. Singh, who had co-founded the company in 1993, filled a plethora of management roles over the firm’s lifespan before he finally stepped down after Concur’s acquisition by German software giant SAP SE (SAP).

The Bottom Line

Penny stocks are extremely volatile and speculative by nature. As most trade on OTC exchanges or via pink sheets, where listing standards are very lax, penny stocks are susceptible to manipulation and fraud. Still, the potential to make thousands of percentages in returns is a strong allure, driving risk-taking investors into taking positions in these securities. Though many penny stocks go bust, if an investor exercises careful fundamental analysis and picks sound management teams, they could find the coveted diamond in the rough.

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