THROW LARGE-CAP SCREENS OUT THE WINDOW!
Why Changing Your Purchase Criteria Can Make You Millions

Investors who come from large cap markets such as the NYSE attempt to apply their usual fundamental screens to penny stocks and always find themselves horrified when they start digging into individual issues. Many worthy penny stock investments are debt laden, have weak or no profits, and only one or two products. After looking at any penny stock using large-cap screening techniques, you'll soon ask yourself, "Who'd invest in this?" I'll tell you who:

People who are smart enough to throw large cap screens out the window when evaluating penny stocks, that's who.

You're going to need a new set of ground rules. Penny stocks, being a completely different beast from large-cap stocks, need to be viewed through a different lens. Here's what you need to remember:

1. Every penny stock is there for a reason. Companies built on good ideas sometimes don't have sufficient access to capital and went to the market for it. They have young, aggressive management. They need to build a foundation. Bad companies are there because they have no product, inadequate product, huge amounts of debt, or compete in an oversaturated marketplace.
2. These companies have warts. If you're looking for the perfect, no lose penny stock investment that you can spot a mile away, it's time to trade elsewhere. Becoming wealthy takes the courage to live with volatility and problems.
3. The real question is which warts are cosmetic and which are going to kill the company. Your job is going to be to become flexible and smart enough with your screens to adjust and find the winners in this market.

Once you've adopted this new viewpoint, you'll need to begin thinking about which screens work and which don't.

• You cannot compare your penny stock easily to competitors. If you think you can, you're probably evaluating the wrong stock. Great penny stock plays work in niche markets and are working one or two products. A company with a new phone technology shouldn't be compared to AT&T. Comparing these, you'll always pick AT&T and you'll potentially miss out on tons of opportunity.
• P/E ratios can, for the most part, be thrown out the window. If your company has no revenues yet because they're exploring a new drug, you aren't going to find any earnings, which is the "E" in P/E ratio. Therefore, searching for P/E isn't normally a wise penny stock screen. Even if a company has a P/E ratio, why would you use this for penny stock analysis? Investors routinely use P/E to evaluate the risk involved in a company. You should be trading penny stocks because you're hoping to make money from the volatility in these investments. If you don't want volatility it's going to be difficult to become wealthy.
• Insider trading, while still helpful, is suspect as a measurement of a stock's worth. In larger companies you may be able to see trends using insider trading data that's publicly available. Penny stocks are so small that owners will usually hang on until the very end or will diversify slowly out of the position because they've had their entire life savings wrapped up in this single project.

Hopefully, you're beginning to see that to be successful, you'll need a new lens when you trade penny stocks. So which fundamental screens are important and which should be disregarded?

While evaluating penny stocks is no more difficult than evaluating large cap stocks (except for access to information, which we review in another article), your methodology must be more fluid than in many large-cap schemes. You won't be able to easily evaluate a single data point. Instead, look to analyze several pieces of data and make a decision based on the consensus.

Here's what I mean:

• Company XYZ has a new drug. They have no revenue and a large research staff. This company will fail every screen for P/E, revenues, and profits you use, and will probably also not pass any debt screens.
• Company ABC just reorganized last year and has a whole new management team and streamlined focus. All year over year data will be nearly irrelevant as the new company regains it's footing.
• Company MNO has a single product that is gaining ground. They have great sales numbers but their cost of sales is through the roof. Although this may be a problem, remember that penny stocks are characterized by quickly arcing sales. The company may have the right team in place to create sales far above current levels.

To me, there are a list of important screens, but they should be melded together to form a complete picture of the firm.

Here are some of the most important penny stock screens:

• Increasing revenues. Although I'll invest in a company with a great potential product, I prefer to see a company that's beginning to catch some wind in their sails (and sales, if you want the pun).
• Alliances. I like to see companies that are attached to larger, more established sales staffs or purchasers. Not only does this help the company get off the ground more quickly, the large company may be a potential buyer down the road.
• Low debt. The majority of penny stock companies are saddled with debt. Whenever I can find a firm without a huge debt burden that company is not only poised to grow more quickly, but it's easier for a more established company to purchase.

If you want to be successful trading penny stocks, all you have to do is change your focus. Traders willing to adapt to a new set of rules stand to profit remarkably from penny stock trading.