When stock markets are weak, a lot of investors see a chance to make some cash from penny stocks. And I’m one of them, but cautious too.

In the past 12 months, the FTSE 100 has been flat over all. So the 2023 drop so far is really just the reverse of those late-2022 gains.

But look at the FTSE Small Cap index. Over the same 12 months, it lost 13%. Lucky for some? Maybe.

The AIM index, home to many very small growth stocks, has dropped by a huge 24% in the same period.

So there’s more risk of losing money with small-cap stocks, including penny stocks, than with big blue-chip ones. But I’m sure most people accept that.

But the converse has to be true. If they tend to fall more in hard times, they’ll surely gain more in good times, right?

It doesn’t matter whether the value is £10bn, or less than £100m. If a company looked good last week, and its share price falls this week with no bad news, it must be better value now, surely.

Looking at the charts again, this time over 10 years, is telling. The FTSE 100 has managed a 16% rise in a decade. But the small-cap index is up 58%.

The AIM index is curious. Over 10 years it’s only made 9%, but it’s had much bigger peaks from time to time. By April 2021, for example, AIM stocks were well ahead, up 75% compared to the Footsie’s 9%.

So looking for penny stocks to buy when they’re down clearly can be a money-making strategy. But I do think it needs a lot more care, in a few key areas.

Rolls-Royce suffered in the Covid crash. That’s a huge FTSE 100 company, and it had the clout to raise the cash it needed to survive. It now looks to me to be set to thrive.

But a tiny company can find it a whole lot harder to raise cash when times are tough. Some of the worst I’ve seen have had to rely on issuing more shares, year after year after year.

I won’t name my worst example, but it’s issued massive quantities of new shares, and pushed the price down to a fraction of a penny. Those who bought at flotation have lost 99.99%.

So, yes, a very small company faces more risk of going bust in a bear market. Or, at least, diluting its shareholders to near zero.

Even without a slump, debt doesn’t sit well with penny stocks for me. And I also don’t like ‘jam tomorrow’ ones with no profits yet. I avoid those, unless I see plausible profit forecasts.

So, for me it comes down to one key thing. And that’s to be far more critical of the financial state of a small company than a large one.

That’s why I buy very few penny stocks. But when I see one that I think is super cheap, I’m in.

The post How to make big money from penny stocks appeared first on The Motley Fool UK.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.