Here at Penny Sleuth HQ we�re often asked what we think about Company A, or Stock B, or Product C. Maybe �often� isn�t strong enough of a word � we get these emails by the hundreds! And while we can�t offer individual investment advice, we certainly can give you the tools to analyze these stocks based on the years we�ve spent in the penny stock trenches.

Most investors realize that there�s something very different about penny socks. After all, how can the smallest companies out there offer some of the biggest returns?

But while small-cap profits can be bigger than those you�d see with a company like General Electric or Exxon Mobil, there are still three red flags that you should be watching out for in your penny stock investments right now: lack of liquidity, paper thin margins, and sparse volume. Keep these three items in check, and your chances of investing your way to profits in 2009 will be greatly increased. More on that in a minute�

1. Lack of Liquidity

When fundamental investors (people who invest on stocks based on their business, assets, and growth potential) talk about liquidity, they�re referring to balance sheet liquidity � a company�s ability to convert their assets into cash in a pinch.

That�s a pretty important characteristic right now.

After all, while cash may seem in short supply during this recession, the small-caps we focus on won�t be getting any bailouts from Uncle Sam anytime soon. That�s why it�s so important to make sure that you�re putting your money in companies that have the wherewithal to survive for the long-term.

When looking at a company�s balance sheet (which you can find for free at sites like Google Finance), the first thing to remember is that cash is king during a recession� the more cash a company has in the bank the longer they�ll be able to survive if times get tougher.

Another valuable measure of a company�s staying power is its interest coverage ratio. The interest coverage ratio divides a company�s earnings before interest and taxes (EBIT) by its interest expenses, and gives investors a glimpse at how easily a firm can make its debt payments. A number above 1.5 is generally a good sign.

2. Paper Thin Margins

While larger companies usually keep their margins in line from quarter to quarter and from year to year, smaller companies don�t always have that same consistency. Net margins, which show what percentage of sales translates to profit, give investors a good idea of how susceptible a company is to declining revenues.

When margins are exceptionally small, watch out � it could mean that your company is a quarter or two away from posting a loss.

The most important thing to look for with a company�s margins is the way they behave over time. Slipping margins could be a sign that a company is losing its footing, whereas slow margin growth could mean that the company is becoming more efficient at turning a profit.

3. Sparse Volume

While our first two red flags focused on a company�s financial statements, sparse volume is all about the stock market. A stock�s �volume� is a term used to describe how many shares traded hands during a given period. Average daily trading volume is a pretty common indicator of how frequently a stock trades, and you can find it just by going to any stock�s Google Finance page.

Volume is important for a very good reason � stocks that don�t have a decent amount of trading activity are incredibly unpredictable. That�s because in the stock market, we � the people who buy and sell the stocks � set the prices. When a stock has low volume, it means that a small number of people have control over that stock�s price, and a relatively small number of shares can drastically skew a company�s value.

It also means that other investors aren�t particularly interested in investing in that company. That�s significant because it means that even the best companies can stay undervalued for long periods of time if they don�t have reasonable volume.

Make sure your small-caps trade daily, or you could be locked in a waiting game to make money on your investment.

Building a Better System

Keeping an eye on these three red flags is a good start when you�re trying to analyze a new penny stock. Remember though, all three of these measures are subjective, so it�ll take some experience before you�ll be able to discern the difference between liquidity that�s �good� or just �average�.

But what if you can�t have your eye on the markets all the time? That�s where stop losses come in.

Basically, a stop loss (or stop, or stop order, etc) is an order with your broker to sell your shares in a particular stock automatically when its price hits a specific level. That means if your shares of Stock A are up 30%, you can set a stop loss to trigger when the stock drops to 25%, guaranteeing your minimum profit.

While there are several different types of stop losses, these three flavors are worth knowing about:

1. Stop Order: Triggers once your stock reaches a specific target price, the stop price.

2. Trailing Stop: Triggers at a specific change in price, measured by either percentage points or dollar value.

3. Stop Limit Order: Similar to the stop order, except for the fact that a limit order is triggered once your stock reaches a specific target price. (i.e. sell high, and re-buy low)

Clearly, the biggest benefit of placing stop losses is the fact that you won�t have to lose sleep over your open positions � if the stocks you own take a big dive, your positions will sell off before any major damage is done. That�s a pretty compelling case for using stops.

Still, that�s not the whole story�

Drawbacks of Stop Losses

The biggest reason that people lose out on stop losses is through short-term fluctuations in stock price. If you have a stop set at 5% below a stock�s current price level, and the stock swings 10% in the week, your stop will trigger and you�ll miss out on the stock�s rebound. As a result setting your stop losses intelligently is essential.

But exactly where to place your stop-losses is another tricky bit of business. It takes even the most skilled traders a good bit of trial and error to learn what works when it comes to setting stop losses.

If you�re a believer in fundamentals, it�s best to think of stop losses as profit keepers. You should place them at the level of gains you�re comfortable walking away with. If one of your positions is up 20%, 15% gains may be the least you�re willing walk away with � if that�s the case, it makes sense to put your stop losses there.

Even if you�re a fundamental investor, stop losses can be most valuable when they�re combined with technical analysis (using chart patterns to determine where a stock�s price is going). After all, technicals are what drag fundamentally sound companies down during a bear market. Unlike with fundamentals, where stop losses can be considered �profit keepers�, you can think of technical stop losses as insurance � a way to ensure that your stock won�t go into freefall.

Stops can be very useful when they�re placed under a stock�s support level (the price level that a stock has trouble falling below). That�s because to a trader, a price level below support generally means that the stock could be breaking out much lower.

Don�t Stop the Stops

Whatever your investing strategy, stop losses can be a valuable part of your investing toolbox. That said, using stop losses and other more complex broker orders can be tricky for beginners � always make sure you understand what you�re doing before you commit money to a trade. Here at the Penny Sleuth, we�ll keep doing our best to provide you with an investing education.

Cheers,

Jonas Elmerraji