Do you remember the time back in elementary school when you came across your first multiple-choice questions? Most likely, you spent a plenty of time to figure out what the correct answer was and another dozen of minutes to know how to get rid of wrong choices.
This is called the process of elimination. You simply eliminate the choices which you know are not true and thus increase your chances of getting the right answers. Just like that!
What if I tell you that you can apply the above method to penny stocks. You think it is NOT doable but actually it is, however one single difference exists here: the number of choices you will have.
A regular multiple-choice test has from four to five options (in standardized tests). As regards penny stocks these options increase to the thousands. Sounds like a very complicated math problem, right? But let me explain that to you in greater detail.
The Fundamental Principles
I pointed that out before in my previous articles but let’s go thru some basics one more time: when dealing with microcaps (or penny stocks) of small-scale companies (with market capitalizations of less or equal to $200 million) the range of available stocks is limited, however that is still around 20,000 companies which are not that easy to handle.
So getting back to our elimination method we have to understand that removing just a few options from the list won’t make any benefit and increase our probability of success. You need to cut over 90% off the market so your odds can significantly rise.
I have been working on this method for over 4 years now. Yes, it took me tens of hours to test it but the patience definitely pays off! I am glad I have finally discovered an approach that helped me shrink the number of choices/options by a reasonable margin.
Do you remember our standardized multiple-choice question with five options? If we eliminate three of them, we come up with a 50/50 chance for each answer.
Well you will probably be surprised but what I have found so far is actually better and even simpler than that. As soon as I start walking you through the basic formulas in a couple of minutes you will find that you are very good at picking hot penny stocks that give nice returns in the short run. And by the way, you will be able to scientifically eliminate 99% of the chunk with the given parameters.
The Well-Known Facts
As you may know most of the risk associated with microcap companies is caused by:
- Limited cash reserves
- Unreliable business model
- Uncertain products
Also, growth rates can be inhibited by:
- Dividend payments (small-scale companies should re-invest their gains rather than pay shareholders)
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So probably your next question will be how to filter everything out to get the necessary microcaps and make money from buying them, correct? First things first:
- Our target is companies with positive cash per share ratio (cash on hand divided by the number of shares) – we want to make sure their business won’t shut down the next day.
- Our target is companies with a reliable gross margin ratio (company’s revenue minus COGS divided by revenue) – we want to make sure their business generates money and stable.
- Our target is companies with solid net profit margins (ratio of net profits to company’s revenue) – we want to make sure their business is ready to expand.
- And our last target is dividend payments or rather the lack of them. Microcap companies have nothing to do with blue chips. Any personnel layoff or payroll issues will affect the financial health of the business. So dividends are not essential here!
Moving on to our arithmetic part and start applying the method to real examples:
First stage is market participants. We have nearly 20,000 companies (19,800 to be precise) with the given limit of $200 million of a market cap. We cut them down to 18,900 with our non-dividend stocks filter. Not a very big decline though but this is only one target out of four mentioned above.
One-step forward and we are on the Net Profit Margin side. And this is actually very important as we have to pick companies with at least 8% in profit margins. A huge cut from 18,900 down to 750 and we are finally getting closer to our ultimate number.
Next stop is cash per share ratio. In our case the positive value we set in is 1. The move from 750 down to 252 and we are almost on the home stretch with our method.
Our last stage is a reliable gross margin ratio and its threshold of at least 40%. Abracadabra and it cuts 252 companies to just 90 and we are finally good to go!
The Figures Can’t Lie
You see, just a number of certain steps and we have made a huge reduction of the field. A cut from 19,800 to just 90 companies and 99% of the risk is out. It saves your time, money and of course nerves. But does it mean you are completely free-risk now and all you need to do is trade the remaining companies that give you handsome and fast profits only?
No, it is the wrong mind-set.
Also, the 99% companies we already threw off did not mean to be unprofitable. It is wrong again!
From a statistical perspective you have much more chance (or call it probability) to become successful while trading those 90 microcaps than the entire 19,800 field. However, when we wipe off our risk exposures we also diminish some of the upside rally capacity which in turn affects our future profits.
You’ve got to be very careful when choosing what penny stocks to trade as companies may be at different stages of their business life cycles.
Looking for a six-figure profit? Then most likely your choice is to stick to a company that’s in a growth stage, has made it through the toddler years and its revenues are actually increasing at lighting speed.
Do Not Fall Into Illusions and Delusions
I assume some you of are still very pessimistic about what I’ve presented above but let me make it clear one more time.
I am not selling you a system that helps you find only top-movers. You can’t find such a system whatsoever as it simply doesn’t exist.
The above method is NOT a system and its main task is to cut risk as per well-known fundamental principles.
And it actually works really well. Back in a day when I was building up my portfolio, the range of selected penny stocks lowered to seven ticker symbols. After a couple of months four of them had gained 35%, 37%, 42% and 55% respectively. The remaining positions were still open with a slight three-digit profit floating. None of the above was down!
I am more than sure there will be a certain percentage of readers who say ‘this is so good to be true’. Well I am not going to change their mind but share with the rest of traders the method which gives an eye-popping income on a regular basis.
The Final Analysis
After everything we’ve covered so far you have to keep in mind that 90 microcaps have to get sorted as well and that’s when the industry analysis comes on stage.
Suppose all the 90 perfectly fit into the arithmetic requirements we’ve presented earlier but how about the average industry ratios, the current market trends, and the shares distribution? I know that kind of due-diligence takes hours of rigorous work but after it is all done you can only see from 6 to 7 tickers on your short list. So you diminish your risk to its very lows.
If there’s anyone here who prefers to take risk instead I can show you another way of filtering the penny stocks – just choose the microcap companies with the record upside and jump into the market!
May the force be with you traders. Patience definitely pays off!