Penny stocks have the ability to turn into giants. A couple of prime examples are Ashtead and JD Sports. However, not all achieve this. In fact, more often than not, small-caps tend to fail.
I look at three main things when I decide to buy a penny stock.
My checklist
- How are the fundamentals? It’s crucial to understand a firm’s balance sheet including cash, debt, and trading history. I’m aware that small-cap stocks often have less information readily available. So if I can’t find much information, I’m more likely to stay away.
- What does the business do? Does it provide an essential or luxury service? Could its offering be obsolete in the future? What’s the shape of the industry it operates in and is it established or a start-up? Plenty of research is needed here.
- Who is the management? I’m more inclined to be bullish towards a stock if there are people running the business who have relevant experience. However, I’m conscious not all penny stocks may have a high-flying executive with a solid track record coming from a blue-chip background.
One stock I own
One small-cap stock in my holdings is Topps Tiles (LSE: TPT). It sells tiles, wood flooring, and other home improvement products, and operates out of many large out-of-town retail outlets, as well as online.
Using my checklist, Topps has a lot of historical data I can access as it has been around for a long time. Using its most recent annual report, for the year ended 30 September 2023, the business looks in a good position. Revenue and profit increased over last year, and its cash and debt positions look favourable. Crucially for me, a dividend was declared, and this is one of the biggest reasons I bought some shares. A dividend yield of 7% is above the FTSE 100 average of 3.8%. However, dividends are never guaranteed.
Next, from an industry perspective, tiles and home improvements aren’t exactly defensive but still important. Topps is set up in a shrewd way whereby it sells to trade customers too. This could be lucrative in the years to come, especially when I think of the housing shortage in the UK that needs to be plugged. Furthermore, it possesses over 20% of the tiling market share in the UK which could serve it well.
Finally, I’m impressed by its management team. Topps’ CEO and CFO both possess vast experience, gained at large blue-chip retail businesses.
Risks and final thoughts
Conversely, there are risks I must be wary of. Its large brick and mortar retail presence is a concern for two reasons. Firstly, shopping habits are changing due to the rise of e-commerce. This could hurt performance and returns. However, the business has moved with the times and does have its own online offering. The other reason is the sheer cost of owning, renting, and maintaining these locations, which can take a hefty bite out of its bottom line.
Overall, I can’t say if Topps will soar towards the FTSE 100 — no one can. However, it’s a solid business, with attractive fundamentals, good leadership, an excellent market share, and offers me passive income.
