Investing in penny stocks can be exciting and very rewarding. These companies’ small size can mean they fly below the radar of big City investors. In my experience, it’s sometimes possible to pick up a hidden bargain that just wouldn’t exist in the FTSE 100 or FTSE 250.
Of course, the flipside of this also applies. Smaller companies may be less well established and more likely to run into financial difficulties.
The two companies I’m looking at today are both relatively small, but they’re profitable and have sound finances, in my view. I think they could both be good investments over the next three to five years. Here’s why.
Value price, quality business?
Car sales group Vertu Motors (LSE: VTU) has 188 franchised dealerships across the UK, with a focus on premium brands such as BMW, Jaguar Land Rover and MINI.
Admittedly, the UK car market is expected to slow this year. But recent trading has been strong and I think Vertu’s forecast price-to-earnings (P/E) ratio of six already reflects a cautious outlook.
Another attraction for me is that the group owns the freehold for many of its dealerships. This means there’s plenty of asset-backing for the share price. If the business runs into trouble, freehold property can usually be used to raise cash.
Vertu’s most recent accounts showed tangible assets of 71p per share, compared to a share price of 56p. The recent acquisition of dealer group Helston Garages means that these figures will have changed slightly, but I think the balance sheet should still be very strong.
What could go wrong? This business has a decent market share and I think it’s well managed. But if the UK suffers a severe recession, profits could fall much further than expected. If that happened, the shares could fall further and the dividend could be cut.
As things stand today though, I think Vertu looks decent value. I reckon this penny stock could perform well in an economic recovery.
Delivering good news
My second pick is distribution group Smiths News (LSE: SNWS). This company has an overnight delivery network that’s used to deliver newspapers and magazines to retailers.
There’s an obvious risk with this business — printed newspaper and magazine circulation is falling steadily. However, according to Smiths the decline is fairly steady and predictable. So far, the company has been able to adjust its network each year to stay profitable at lower volumes.
The long-term uncertainty surrounding this business is reflected in a super-low valuation. Smiths News currently trades on just five times forecast earnings, with a well-covered 7% dividend yield.
The risk is that at some point, someone will probably need to find a new use for the group’s overnight network. Otherwise it could become unsustainable.
Despite this, the next few years seem pretty safe. Smiths has already secured long-term contracts for 46% of its newspaper and magazine revenue. A recent deal with Telegraph Media Group runs to 2029, for example.
If the dividend is held, then the 7% yield would provide a 35% return in five years, even if the shares don’t move.
I wouldn’t bet the farm on this stock, but I think it probably offers a good opportunity at current levels.