MARC HASENFUSS: The pennystocks that could make you rich

There’s one quasi-asset class for which investors on the JSE always appear to be spoilt for choice — the pennystock sector.

At the time of writing there was a surfeit of stocks, spread across most counters, that are trading below 50c (which, for the purpose of this article, is the Financial Mail’s defined price limit for pennystocks).

Pennystocks, with their high-risk/high-reward attributes, have always fascinated mainly the retail investment community. The eternal hitch is that the high rewards tend – in share community chatter – to be emphasised over the sometimes diabolically high risks.

A share reaches pennystock levels for good reasons. An operational or acquisitive strategy may have gone awry, the balance sheet may be dangerously strained, management may have proved inept under pressure, the main shareholders may be in conflict or the company’s niche may be overtraded or no longer relevant.

Common sense might dictate that it’s far more prudent for investors to concentrate their efforts on backing companies that don’t face such headwinds and hitches.

But there is a fixation, in some quarters, around securing salvageable value in a smouldering corporate wreck.

In truth, the pennystock winners have often been spectacular — and, in some instances, 100-baggers. Older readers will remember top-notch companies like private-education group AdvTech (now trading around R18 on the JSE), Onelogix (300c), Adapt IT (995c) and Metrofile (450c), as well as enduring empowerment groups Brimstone (R14.50) and AEEI (350c) all trading at pennystock levels at various times. These companies now pay dividends in excess of their respective pennystock share prices.

More recently there have been more than a handful of astounding successes that will reinforce the notion that every portfolio should have some exposure to pennystocks.

Financial services counter Finbond went from a trading range of 6c and 18c in 2013 and 2014 to current levels of 345c, while telecoms specialist Huge Group shifted from a 31c record low in 2014 to 865c at present.

Less spectacular, but still richly rewarding, were the moves by logistics specialist Santova (which touched a low of 10c in 2012), communications technology specialist Alaris (5c in 2012), services group CSG Holdings (25c in 2013), human resourcing specialist Workforce (34c in 2013) and technology services group Ansys (13c in 2013).

But these jaw-dropping gains need to be contrasted with numerous pennystock fizzles.

Over the past few years shareholders found little joy in backing pennystock counters like food franchisor Kingco, retailer Global Villages (which went missing without a trace), cosmetics group Beige, security cluster Command, food services counter Ububele, small bank Blue Financial Services, paint group Chemspec, steel merchant Alert, platinum junior Platfields, technology groups Gijima and Beget as well as golf estate developer Pinnacle Point, low-cost-housing developer RBA Holdings, hotel operator Queensgate, meat group Best Cut, asset manager StratCorp and low-cost airline 1Time Holdings (to name a few).

If there is a key to investing successfully in pennystocks it is determining what informed the change in investor sentiment for AdvTech, Huge or Workforce — and why Chemspec, Beget or Queensgate never found traction.

There are a number of factors to weigh up when perusing pennystocks.

First and foremost, avoid companies where executives are prone to uttering excuses around (under)performance, and rather investigate the (sadly rare) opportunities where management addresses challenges frankly.

And punters should reality-check the upbeat utterances of executives who insist the market is misunderstanding a company.

A company delivering affordable private-school services or cost-effective telecoms solutions may well have a better niche than companies pitching new products against giants in the competitive beverage or food sectors.

Punters should also prefer companies that are generating operational cash flows and steady margins to those that highlight revenue growth that comes at a cost. The existence of meaningful cash flow is probably the key fundamental consideration when mulling a pennystock opportunity.

Naturally, gearing and solvency levels should be intensely scrutinised — especially since more than a few pennystocks have been dragged towards liquidation by creditors or banks at a time when management was waxing lyrical about prospects.

Another key consideration is assessing the calibre of influential or controlling shareholders, particularly if a company needs to embark on fundraising exercises. A large shareholder with deep pockets, patience and an ability to add value can make a huge difference to a turnaround effort or strategic repositioning.

The emergence of the savvy PSG Private Equity at CSG Holdings and Alaris triggered positive changes at these counters.

The importance of reporting audited financial results, releasing annual reports and hosting AGMs on time should not be overlooked. Companies that fall foul of these basic contracts with shareholders are best avoided.

Consistency in operational strategy, especially during stressful trading periods, is another positive attribute. Punters should worry when strain in the core business prompts a sudden and dramatic change in strategic direction — often accompanied by issuing poorly rated scrip to make new acquisitions.

Some of the big pennystock successes have been when companies (AdvTech, Onelogix and Huge) stuck to their knitting. Admittedly, clever adaptations to business models have also worked — most notably Finbond (a broadening of its microlending niche) and CSG (diversifying its services offering).

Pennystock punters should also gauge whether executives would grasp the nettle when it comes to securing value for shareholders. Sometimes a difficult decision needs to be taken on underwhelming or cash-burning operations — which can involve selling off or closing specific operational assets to preclude a complete erosion of shareholder value. The experienced Peter Watt, formerly CEO of Business Connexion, did a stout job in salvaging some value for shareholders in the struggling call-centre group Dialogue, some years back.

Comparing pennystocks to their more successful countermates can be useful. Sometimes two companies plying the same trade can enjoy vastly different levels of success. Prime examples would be cabling and lighting groups ARB Holdings, which has produced consistent profits, and South Ocean, which has been a shocker in terms of profits. Another would be building supplies groups Afrimat (profitable and dividend paying since listing in 2007) and WG Wearne (now struggling for survival), where the timing and price paid for acquisitions resulted in vastly different fortunes.

One of the most over-used gauges for assessing pennystocks is determining the "hard" net asset value (NAV) of a company. This, unfortunately, can also be a deceptive gauge, with asset values — set by management or independent parties — often bearing little resemblance to reality. Building supplies group Infrasors boasted a NAV well in excess of its share price — underpinned to an extent by properties.

When Afrimat bought out Infrasors the property values were written down dramatically.

NAV is just a number — unless investors can determine that the estimate is robust.

As indicated earlier, there are many pennystock opportunities on the JSE. Some counters, like Awethu Breweries, seem to have been in pennystock range for an eternity, while others have gradually dribbled down to that level as prospects dimmed or initiatives came unstuck.

The Financial Mail would not recommend that investors commit a serious portion of their life savings to pennystocks. But for those with the capacity to flirt with higher-risk scenarios, we would suggest a closer look at these four.

Purple Group (40c): This financial services group has a specialist asset management and trading offering — but has more recently developed a potentially disruptive stockbroking offering with EasyEquities, a low-cost platform offering the convenience of fractional share ownership for small investors. EasyEquities needs a big boost in volumes to reach sustainable profitability and in the six months to end-February, revenue of R3.4m did not come close to covering costs of R18m. But the EasyEquities platform has enormous potential, and if Purple can snag a big pocketed partner (hello Sygnia?) the push for profitability may be accelerated.

BSI Steel (38c): Prospects for the SA steel industry have been brittle for a while, and consequently few market watchers pay much attention to this counter. BSI, however, has remained profitable, and even paid a dividend for the past two financial years. Interim earnings came in at 4.2c/share, but longer-term prospects hinge on government’s success in addressing certain challenges faced by primary steel makers and downstream manufacturers. BSI has done well to trim its operating costs, and hopefully there will be further successes apparent in the margin when full-year results to end-February are published. Cash flow at the interim stage turned negative to the tune of R36m, but an aggressive approach to slash stock levels should offer more reassuring reading at financial year-end.

Sentula Mining (30c): The mining services corner, like the steel sector, is not the most glamorous area of the JSE at the moment. Sentula, though, has endured a prolonged turnaround effort that might finally be gaining some traction. Deep-value investment group RECM & Calibre has emerged as an influential strategic shareholder, bringing with it the patience and resources needed to drag Sentula back into the black. There is still a way to go at Sentula, but it holds solid operational assets in JEF Drill & Blast and Ritchie Crane Hire that have weathered the downturn in the commodity cycle well. The share price has doubled from the 15c record low recorded in July last year. Sceptics may argue that Sentula is binary — its prospects dependent on managing to survive until the upswing in local mining activity. The Financial Mail thinks there is a good chance that Sentula, perhaps in a slimmed-down mode, will endure until better times.

Primeserv (48c): The human resourcing sector has pretty much seen the last remnants of positive sentiment swept away by government’s aversion to labour broking. Still, Primeserv is making money, as indicated by a trading statement for the year to end-March that pencilled in headline earnings of almost 18c/share. Much like Workforce, which has reinvented itself with some smart earnings-enhancing acquisitions, Primeserv has a distinctly blue-collar bent. The interim gross margins were decent at 16% with half-year operational cash flows more than matching operating profits. There could be more interest in the share if a dividend for the year to end-March is generous.