How to identify the best penny stocks in Canada

Opportunities among the best penny stocks in Canada couldn’t be more enticing as the economy keeps growing despite higher interest rates.

With preliminary data for May showing GDP growth of 0.4 per cent, the Bank of Canada likely has at least one more rate hike in store, which should stoke slowdown fears and continue depressing share prices among these high-potential small and micro-cap issuers.

Penny stocks tend to have a higher beta, meaning they overshoot the broader Canadian market on the upside and downside, generating undervalued entry points for prospective investors well-adept at identifying misunderstood businesses with better prospects than the market recognizes.

The question then becomes: How do we narrow down the small and micro-cap Canadian universe to only those companies with the best probability of generating exponential long-term returns?

Let’s break down the answer in three easy steps.

1. Screen for healthy companies at cheap valuations

The first step in our quest to find the best penny stocks in Canada is to screen penny stocks for profitability and low debt, such that we’re left with the highest-earning and least encumbered among the lot.

Using The Globe & Mail’s stock screener, we search for companies under the following parameters:

• Price-to-earnings ratio up to 10
• Debt-to-equity ratio up to 0.5
• Last price below C$1
• Market capitalization up to C$1 billion

This resulted in 48 companies, which you can view at the end of this article sorted from the lowest PE ratio (take a moment to review them before returning to finish step 1).

Having dwindled an initial pool of thousands of companies spread across the TSX, TSXV and CSE down to a more manageable group, we’ve left ourselves with two possible paths forward.

The first path involves taking a page out of Joel Greenblatt’s The Little Book That Still Beats The Market and purchasing equal-weighted positions in the 20 cheapest, lowest-debt stocks in our screener, holding them for at least one year, then selling them to reap gains and harvest losses before rebalancing into new positions. This systematic, index-type approach ensures diversification, maximizes after-tax returns, and allows you to invest prudently without extensive research.

The second path, which we’ll detail in step 2, calls for applying a full due-diligence process to certain names on our list, whether based on valuation, personal interest, or an assessment of an industry’s future market demand, with the goal of building conviction in longer-term holding periods. Thanks to our screener, any choice you make is already favorable from a fundamentals point of view.

2. Performing further fundamental and qualitative analysis

When it comes to in-depth stock analysis, the best penny stocks in Canada differentiate themselves by meeting unmet needs in growing industries primed for the taking of market share.

The best way to begin your investigation in this direction is to choose a company from our list and read its latest investor presentation, which you can usually find on its official website. Here you’ll learn about how a company views its role within its industry and how it expects operations to unfold into the future. Sherritt International’s Q1 earnings call presentation is a good place to start, as we’ve previously highlighted the company’s attractive cash flows in our Cash-Rich Report.

You can then input the company’s name into a data provider like Stockhouse and slowly make your way through its past year’s worth of news releases for further insights. Stockhouse will also provide you with full financial results going back five years, enabling you to scan for trends in earnings, expenses, inventory and cash management, among others, to continue honing your view.

This work should result in the formation of a thesis about how your chosen company will perform over three, five, or even 10-plus years to serve as a benchmark for its inclusion in your portfolio.

The thesis’ individual components may include growth in profits and revenue, definitive agreements for letters of intent currently in place, the company fulfilling or beating yearly outlooks, or any other measures your research deems appropriate.

The thesis will also afford you peace of mind when your shares inevitably dip below your purchase price, and perhaps allow you to purchase more should you determine the drop to be unwarranted given all you know about the company.

3. Delineate an exit strategy

Though it sounds obvious, it can be an incredibly difficult task to determine when to sell a position, such that your best penny stocks in Canada turn into some of your best portfolio returns. How should one go about this, supposing you leave Greenblatt’s method in favour of more idiosyncratic decision-making?

The most important point to remember about exit strategies is that they are necessary and approximate:

• They are necessary to make sure you end up taking profits to fund your life’s goals, the underlying reasons for investing in the first place
• They are approximate because there is no sure way to determine a stock’s maximum value within your chosen investment period, meaning that you, and every other investor on the planet, are likely to leave gains on the table when you sell

The best course of action, then, given the estimation at the heart of stock picking, is to enhance your investment theses with reasonable ranges for revenue, profit, project progress, and all other components they take into account, as well as grace periods for the company to recover should it fall short of your expectations.

If a company outlasts its recovery time, or satisfies your longer-term thesis, you should sell and move on to other prospective candidates.

You now have all the tools necessary to identify the best penny stocks in Canada and set yourself up for investment success. Make sure to refresh our screener every few months, and you’ll have no shortage of potential holdings to consider.

Join the discussion: Find out what everybody’s saying about penny stocks in Canada, and other hot stock topics, on Stockhouse’s stock forums and message boards.

The material provided in this article is for information only and should not be treated as investment advice. For full disclaimer information, please click here.

Stock screener: Best penny stocks in Canada