How to Find Penny Stocks Before They Explode
By Edward Sylvan
Everybody wants to find the next penny stock before it explodes.
Go through the penny stock subreddits and you’ll see people asking the same question. How do you find these stocks before everybody else?
Most of the answers are about volume, screeners, technical indicators, Discord rooms, and news. All of those answers are related to day or swing trading.
Not everyone wants to sit in front of six monitors watching charts all day. As a former trader at an investment bank, I am qualified to say not everyone has the experience, temperament, or time to compete against professional traders, market makers, and quantitative trading systems executing thousands of transactions per second.
Don’t get me wrong, there’s nothing wrong with that strategy. Day traders who trade penny stocks are an important part of the market. They provide trading activity and liquidity that allows other investors to trade.
But I think we’re missing something.
Why are we only looking at buying shares in the market? Why aren’t we looking at the companies that need money?
I now sit on the management side as CEO of a publicly traded company, and I can tell you that smaller public companies are constantly looking for money. Part of my job as CEO is to raise capital, negotiate financing agreements, and issue shares to new investors.
It’s needed to fund operations, make an acquisition, execute the business plan, and sometimes just to survive or stay compliant with listing requirements.
I know how investors end up owning millions of shares in small public companies long before the trading crowd shows up.
I know this because I’m the one who sold them those shares.
I call this approach Capital Formation Trading (CFT).
What Is Capital Formation Trading?
Capital Formation Trading is the name I’ve given to an approach that looks at small publicly traded companies from the financing side of the business.
Instead of starting with a chart, you start with the company.
You look at what management is trying to accomplish, how much capital it needs, what debt it already has, and how an investor might participate.
You can still buy shares on the open market. There’s nothing about CFT that says you have to negotiate a financing agreement with a company.
But buying shares from another investor isn’t the same thing as providing much-needed working capital directly to the business.
When you buy a penny stock through your brokerage account, your money generally goes to the person selling you those shares.
When you invest directly in a company’s newly issued securities, the company receives the money.
And that money could be used to execute its business plan.
That’s a big difference.
There are also other ways investors participate in financing small public companies.
Some lend money through convertible notes. Some negotiate direct equity investments. Others acquire outstanding debt and attempt to restructure it. And some simply study those financing arrangements before deciding whether to buy shares in the market.
These are not new financial instruments. They’ve been around for years.
What I’m introducing is a way for penny stock investors to think about them together.
Of course, not every investor can participate in every type of financing. Some transactions require substantial capital, investor qualifications, legal work, and compliance with securities regulations. They can also create restrictions on when shares may be sold.
But understanding how these transactions work is valuable even if you never participate directly.
Instead of only asking which penny stock is going to run, start asking which companies are trying to raise capital.
What I find interesting is that some of these investors aren’t approaching the company like stock traders at all.
They’re approaching it more like venture capitalists.
Why Are So Many Penny Stock Companies Public in the First Place?
Think about this for a minute.
A large number of companies trading on the OTC market are small businesses.
Some are startups. Some are developing products. Some have very little or no revenue at all.
Many are high-risk businesses that need a continuous flow of new money just to stay alive.
Sound familiar?
That’s not much different from thousands of startups in Silicon Valley.
One difference is where they’re looking for the money.
A private startup might spend years raising money from angel investors and venture capital firms.
An early-stage public company may be trying to raise money from investors through the public capital markets.
In fact, access to capital is one of the main reasons many small companies choose to become publicly traded in the first place.
Going public doesn’t guarantee they’ll raise any money. But it can open up additional financing opportunities.
These companies need that money for a reason.
They need to develop products, hire people, find customers, expand operations, and hopefully reach the point where the business starts generating enough revenue to support itself.
Some will make it.
A lot won’t.
That’s the risk.
The possibility that one of these little companies could eventually become something much bigger is what attracts certain investors to penny stocks.
But here’s the question I want people to consider.
If investors are willing to take on such high risk in buying shares of these companies, why aren’t more of them looking at how the companies are actually financed?
Think Like the Person Financing the Business
When a venture capitalist looks at a startup, they’re not sitting there waiting for a moving average to cross another moving average.
They’re looking at the business.
Who’s running it? What’s the product? Is there a market for it? How much money does management need? Can they get attention in a crowded marketplace? What can they accomplish with that money?
That’s how I think more people should approach penny stock investing.
Let’s say a small public company needs $500,000 to finish developing a product and get it into the market.
A momentum trader might be looking at its stock trading at three cents and wondering whether it could run to six cents.
But somebody looking at the company from a capital formation perspective might be asking a completely different question.
What happens if this company gets the $500,000?
Can management finish the product? Can they start selling it? Can those sales turn into meaningful revenue? And could that revenue eventually turn into earnings?
Because that’s what raising capital is supposed to accomplish.
The company raises money so it can execute its business plan. The business plan is supposed to produce revenue. And hopefully, that revenue eventually produces earnings.
It doesn’t always work out that way. Sometimes management burns through the money and has very little to show for it.
But at least now we’re talking about the business instead of just the stock price.
And I think that’s a conversation more penny stock investors should be having.
Is the Company Broken, or Does It Just Need Money?
This is another thing I want investors to think about.
Just because a company is trading for pennies doesn’t necessarily mean its business has no value.
Maybe it has a product people want.
Maybe it has customers.
Maybe it has revenue.
But it also has debt, expensive financing, or not enough working capital to execute its plan.
Now, that doesn’t automatically make it a good investment.
There are plenty of companies trading for pennies because the underlying business simply isn’t working.
And there are companies that restructure their debt and survive while existing common shareholders lose everything.
That’s why you need to understand the company’s balance sheet and who has a claim on its assets. In some cases, debt on a company’s books can be turned into equity for investors.
But I think there’s a real difference between looking at a stock and asking whether it’s going to run tomorrow and looking at a business and asking what it would take for that business to become financially viable.
Those are two very different ways of approaching risk.
There’s More Than One Way to Take Risk in Penny Stocks
This is really the point I’m trying to make.
Penny stocks are risky. We all know that.
People are attracted to them because they’re looking for opportunities that could produce substantial returns.
But why does almost every conversation about making money with penny stocks begin and end with day trading?
What about the investor who wants to research a company for three months?
What about somebody who wants to understand its debt?
What about the investor who’s willing to hold a position while management tries to execute its business plan?
Or somebody who has the resources and qualifications to negotiate a financing arrangement directly with the company?
Those investors are taking risks too.
They’re just approaching those risks differently.
And I think there’s room for more than one approach.
Capital Formation Trading isn’t automatically safer than momentum trading. In some cases, it may be considerably riskier.
A company can fail. A lender can lose their money. Existing shareholders can be diluted. Shares acquired through private transactions can be restricted or difficult to sell.
And investing early in a company doesn’t mean you’re going to make money.
But not everybody wants to compete with professional day traders.
Some people might be better suited to studying businesses, understanding financial statements, and taking a longer-term view of speculative investments.
I think those people should at least be introduced to the financing side of penny stocks.
Why I’m Talking About This
I’ve spent years on the company side of public-market financing.
I’ve negotiated with investors, dealt with the realities of raising capital, and seen how financing decisions can affect a company’s ability to move forward.
That’s where my perspective comes from.
I’m not looking at this as somebody who has only traded penny stocks from a brokerage account.
I’m looking at it as the person who sits across the table from investors providing the money.
And I think there’s a lot that individual investors can learn from understanding that side of the business.
A Real Example: Alpine 4 Technologies
Here’s an example.
Alpine 4 Technologies (ALPP).
Back in November 2019, while Alpine 4 was trading on OTCQB, the company issued a $35,000 convertible note.
The terms included:
$35,000 principal
15% annual interest
A conversion price of $0.15 per share
The company’s subsequent filings indicate that the note had been fully converted by the end of 2020.
Now look at what happened to the stock.
In the first quarter of 2021, ALPP traded as high as $8.51.
That’s more than 56 times the note’s stated conversion price, assuming both figures are compared on the same historical share basis.
Think about that for a minute.
At $0.15 per share, $35,000 could theoretically convert into approximately 233,333 shares.
At $8.51, those shares would have had a market value of nearly $2 million.
But that doesn’t mean the investor actually made $2 million.
Still, the financing was documented well before the major price movement. That’s what makes the transaction worth studying.
Instead of only looking at the stock’s trading history, look at the financing that took place before the rally.
That’s the point of Capital Formation Trading.
Follow the Money
Don’t only look at who’s buying the stock. Start looking at who’s financing the company.
The next time you’re looking at a penny stock, don’t just ask yourself how high the price might go.
Ask what the company actually does.
Ask why it needs money.
Ask who’s financing it.
Ask what management plans to accomplish with that financing.
And ask yourself: Am I providing the exit liquidity for the person who took the Capital Formation Trade?
Because when you start asking those questions, you’re no longer looking at penny stocks only as something to trade.
You’re starting to look at them as businesses that need capital.
And that opens up an entirely different conversation about investing.
Momentum traders follow the price. Capital Formation Traders follow the money.
About the Author
Edward Sylvan is CEO of Sycamore Entertainment Group, Inc., a publicly traded entertainment company. Capital Formation Trading (CFT) is the name he has developed for an educational investment approach informed by his experience negotiating corporate financing transactions and raising capital.
Further Reading — SEC Investor Resources
For investors interested in understanding how companies raise capital, the SEC provides information on private offerings, investor qualifications, and securities resale restrictions.
Disclaimer: This article is educational commentary, not investment advice or an offer to buy or sell securities. Penny stocks and financing transactions involving small public companies are highly speculative and can result in the loss of an entire investment. Certain transactions require investor qualifications, legal review, and compliance with securities regulations. Nothing in this article is a solicitation involving Sycamore Entertainment Group securities.