Smaller Companies: Beware penny shares that could cost a small fortune

THE silly season could be upon us. There have been reported sightings of green shoots, and penny stocks are in the ascendancy. Small investors beware. Prices of many penny stocks have lifted off the bottom over the past two months. But some of the rising stocks, which were poor, high- investment risks two months ago, remain poor, high-investment risks.

Price rises of more than 100 per cent since the start of the year are not uncommon. In the past three months some share values have tripled, quadrupled and even quintupled.

The fuel for many of the rises, however, has been little other than a return to old-fashioned speculative buying by professional and private investors alike.

Private investors have come out of the woodwork with a vengeance. Trading volume in non- Footsie stocks has been high most days this year. In many individual instances, millions of shares have changed hands daily, with trading driven by falling interest rates and the belief that economic recovery must happen sooner rather than later.

The danger is that falling interest rates will merely delay the inevitable demise of some smaller companies, many of which are being perpetually squeezed by much healthier rivals. Though the benefits of a recovery would quickly feed through to smaller companies, there is no evidence to suggest that an economic revival is just around the corner.

But to be overly bearish on the investment prospects for smaller companies would be a mistake. Many have survived the recession and will undoubtedly prosper from a recovery.

While there are no rules for investment, investors should be mindful of some basic guidelines. One of the biggest, most costly oversights is the belief that a share price of 10p is cheap and one of 500p expensive.

There are dozens of fallen stars clustered around the 10p mark, including Brent Walker, Cannon Street Investments and Lep Group. And despite rises over the past month of 73 per cent for Cannon, 137 per cent for Brent and 236 per cent for Lep, none can be construed as a cheap investment.

Brent is in hock to numerous banks, Cannon needs to make disposals to cut debts, and Lep remains in casualty, attended by David James, the company doctor.

Brent, Cannon and Lep are obvious beneficiaries of cheaper money, but investors, particularly those looking for alternative homes for money in building society accounts, should consider criteria other than falling interest rates.

Spreading the risk over a diversified portfolio of shares can be achieved through smaller company investment trusts, some of which are trading at discounts to net assets.

Another simple idea is to look out for companies with solid balance sheets, which give them scope to develop - recovery or not.

At the same time, be wary of companies that have not made prudent adjustments for lower property values; gearing levels may be much higher than they seem. Even the City is still being wrong-footed by companies announcing huge property write- downs.

And never be shy of taking profits, a useful tool for building up an investment portfolio.