Why I think penny shares are poised to profit from the financial wreck…

The sovereign debt crisis is creating uncertainty in the world economy. The volatility it’s caused on stock markets means investors the world over feel panicked.

But there are several reasons I think the worst is behind us. And in this article I want to show you why I think the crisis will breed a new enthusiasm for stocks.

To start with, the sound of alarm bells in financial markets should induce political leaders on both sides of the Atlantic to show some real leadership. They have to.

Financial markets are now demanding that politicians get a grip. In the Eurozone this is starting to happen. This is what the markets want to see, and this is what could restore confidence.

Here are my 4 key lessons for investing during these volatile times…

1)  Ignore the day-to-day moves and focus on the long term

The longer you hold a share the more the share price will be determined by the progress of the underlying business. The shorter you hold the share the more its price will be determined by market sentiment. As we know, this is extremely fickle and unpredictable and, frankly, unless a company has released some news to the market to explain a change in the share price, it is best ignored.

Many people that I meet today have live share prices on their Blackberry or iPhone.

They seem to follow every tick, up and down. I can’t see any value in that whatsoever. It’s likely to stress you out and cause you to overtrade. For sure the providers of these services might make money out of them. But over-trading is a sure way for investors to reduce their returns.

In Red Hot Penny Shares I look for small companies that hold the potential to deliver high returns. I’m interested in the longer term, allowing time for these exciting businesses to perform.

Of course, it doesn’t always work out. Experience shows that while there are plenty of penny shares that have a good story, many fail to fulfil their potential. So it is absolutely crucial that our stock picks have the potential to ‘win big’.

2)  The old safe havens are hopeless

Across Europe investors have lost confidence in supposedly safe government bonds and bank deposits, and the situation in the USA is little better. That the UK, with its massive budgetary deficit, should be considered a ‘safe haven’ tells you all you need to know about the rest.

The immediate danger now is of a new banking crisis and a credit crunch. That is bad news for business. But the real message of this prolonged period of difficulty is that it does not make sense to lend money to those who cannot repay.

Many of the older generation have much of their wealth tied up in property. But increasing life expectancy is making our pension arrangements less and less adequate. Faced with this, many will be planning to turn some of the cash that they have tied up in bricks and mortar into cash that they can actually spend. This can only depress house prices. For me UK property is, by and large, a hopeless investment.

But that is nothing new. What is new is that putting our money in the bank hardly seems any better. You could argue that since UK bank customers have up to £85,000 of their deposits guaranteed by the Government there is nothing to worry about. But what would happen if we all had to call upon that guarantee?

Risk is being reassessed. Assets such as government bonds and bank deposits no longer appear as safe as they were once considered to be. Investment into wealth-creating business, on the other hand, now makes more sense than ever both for individual investors and national economies. In the long run this crisis should lead to a renewed emphasis on stock market investment into business.

I mean what would you rather do? For 5% per year you can lend your money to Italy, which does not even collect much of its taxes and is run by an ageing lothario – or you can put it to work in genuinely wealth-creating enterprises that can, if things go according to plan, could give you an annual return of 10%, 15%, 20% or more?

I’ll be recommending to you the most outstanding, potentially wealth creating stories of the day – in technology, energy, biotech and much more. I will tell you all about them in Red Hot Penny Shares.

3)  The market will win the battle

It might seem contrarian given the recent bloodshed in the markets and some of the more doom-laden commentary around at the moment. But I strongly believe there's a great opportunity ahead to make money in stocks. I'll show you why.

Let me start by explaining a bit about my own investment strategy. I have a diversified share portfolio, and I take a long-term view. I have some dividend paying stocks for income. But what I really like is to find what I think are great small businesses and buy in early. Fast-growing companies appeal to me because they can create so much value, both for their customers and for me as an investor.

Of course, things sometimes go wrong – new technology from a competitor… a dry oil well… a failed clinical trial, that's the nature of the game. But I'm looking for big rewards here – so I have to take on that extra risk. But what really bothers me is when these exciting little companies are prevented from succeeding and creating wealth by Government bureaucracy and over-spending. More on that in a moment…

Why I'm getting worried about my cash

So I can afford to take a long-term view, as well as owning stocks I also hold enough cash to see me through in the short term. This is a simple strategy. But now something strange is happening…

To the extent that I have worried in the past, my worries have always been about my share portfolio. Even with plenty of monitoring, every now and then something comes out of left field to strike a blow at its value, which is disconcerting. But I have never worried about my cash – until now. 

I do all the sensible things. I don't chase the highest yields. I stick to National Savings Certificates and banks where deposits are guaranteed by the Government. So really, I should not have anything to worry about at all. But I am uneasy.

If the Government was actually called upon to meet all of its guarantees and 'promises to pay the holder' I'm not sure it could do so. In essence, I'm lending to a profligate outfit that can only meet its undertakings by sustaining the confidence of its creditors – and that confidence is wearing thin.

The heart of the matter is that the vast majority of government spending does not generate a financial return. Let me give you an example from Canada, a supposedly prudent country.

Three years ago my step-daughter, who lives in Vancouver, got a job with the German software giant SAP. Within a year she gave birth to her first child. SAP was required to hold her job for twelve months, while the Canadian government paid her half of her SAP salary to stay at home and raise the baby.

After a year she went back to work – and immediately became pregnant again. Now she is on her second stint of maternity leave, paid for by the Canadian tax-payer.

This is all very laudable and no doubt secures the feminine vote, but financially it's crazy. Unless you believe that somebody looked after exclusively by his or her mother in the first year of life is going to become super-productive later on, this 'investment' by the Canadian Government will not yield a financial return.

How the state treats business with contempt

This is the problem. Government spending can create activity and it can achieve useful social ends. But – other than indirectly – it does not create wealth. Wealth creation comes from paying two and two for inputs of labour, materials and whatever else and creating a product that somebody thinks is worth more than four.

From this real wealth creation successful companies are able to repay shareholders. Governments on the other hand cannot repay their creditors out of created value. They can only do so by appropriating the money through taxation or borrowing it from somebody else. What we see today is a massive reliance upon the latter, which is simply unsustainable.

Now investors and businessmen have had enough. Recently I met two men who run small but successful UK businesses. Both told me that they simply won't employ any more new staff. "It's just too complicated," they explained, "and too difficult to get rid of people if it becomes necessary."

In the USA, too, business has had enough of over-regulation, over-taxation, Government over-spending and a lack of political leadership. In an impassioned television appearance, Starbucks CEO Howard Shultz said that publicly listed US corporations are sitting on one trillion dollars of cash – but they will not commit the cash to job-creating investment until the US Government squares up to its budgetary responsibilities and gets off their back.

For the last decade Governments have treated wealth creating business with contempt. They buried it in regulation, taxed it to the bone and took its hard work for granted.

No wonder stock markets have performed badly. Now, though, like it or not, Governments are being forced to acknowledge the importance of business. For some the transition will be an ideological challenge. But we are at a turning point. The pursuit of wealth can no longer be ridiculed.

That must be good for business, and for long-suffering stock market investors. Where am I looking to invest? I'm looking at innovative companies that are creating products and services that are in great demand.

My top sectors for the future

I'm bullish on natural resources like oil and gas, coal, copper and zinc. The things the world will always need. But I'm also very excited about opportunities in technology and especially biotech and pharmaceuticals. After all, no matter how hard things get, we're always going to pay-up to look after our health. It's a great business to be in.

I'll keep on digging around for great investment ideas that are involved in these exciting areas. And I’ll be letting readers of Red Hot Penny Shares know, the moment I find them.

4)  Don’t blindly follow the herd into blue chip stocks

Mr John Farmer is a private investor. I picture a man of good British stock, grounded in our island’s culture – an upstanding citizen and a patriot.

He is proud. He likes to run his own life because he reckons he can do it better than anyone can do it for him. He is also thrifty. His luxuries are an occasional glass of good wine and weekend breaks with his wife. And he has watched in horror as his fellow citizens have gorged themselves on borrowed money and shakes his head in despair at the state of the nation.

He is an intelligent man. He knows that investment into funds will do nothing except line the pockets of financiers. So he invests directly into shares. He gets his ideas from the Daily Telegraph and from his golfing partners. He will be the first to admit that he is no accountant. But he knows a thing or two about business and fancies that he is pretty shrewd.

Mr John Farmer is no mythical figure. He is a loyal shareholder in a blue chip company that has done very little to repay his loyalty. This is a company whose shares have plummeted since Mr Farmer has owned them. And yet, Mr Farmer has clung on as this company’s directors have paid themselves enormous salaries and bonuses.

Do you feel sorry for Mr Farmer? Well you shouldn’t. Because for all his fine qualities, he only has himself to blame.

“This seems to me to be a colossal disaster”

Mr Farmer is a shareholder in Cable & Wireless Worldwide and recently he trooped along to the company’s annual general meeting. The chairman went through the usual routine and then Mr Farmer got to his feet. This was his moment and he was determined not to waste it. Referring to the millions handed out to C&W’s directors Mr Farmer said “vast amounts have been paid out to the supposed prime movers in this enterprise and still the future is uncertain”. He accused the board of “arrogance” and declared, “this seems to me to be a colossal disaster and I have scant confidence in the future”.

Now, I admit that I don’t know too much about Cable & Wireless Worldwide – which emerged after Cable & Wireless was split in two last year. It is not the sort of company that I would waste my time on. But I can see that the share price has more than halved since the demerger last year. And that hardly seems to justify the £10m payment lobbed out to chief executive John Pluthero for what is laughingly called a ‘long term incentive plan’ or £650,000 dished out to the former CEO as compensation for loss of office.

Even the new chairman, John Barton, accepts that things have not gone to plan. “The demerger from its sister company Cable & Wireless Communications has not proved successful”, he admitted. “We were far too optimistic… we created expectations that quite frankly we didn’t live up to. It hasn’t created any value at all.”

Why on earth would you invest in this company?

So what have the City’s big investors, who look after all our money, done about this? They have really shaken their rattles! Oh yes! A quarter, no less, refused to back the company’s remuneration report! Almost a third voted against the remuneration plan! And – wait for it – 9% ‘withheld their votes’! No wonder the senior independent director Penny Hughes (salary £85,000) admitted that “it makes you stop and think”.

But look, even if I think the directors of Cable & Wireless Worldwide are overpaid  and that the business is going nowhere, it doesn’t matter.

What irritates me is the attitude of Mr John Farmer. If you think this business is so rotten Mr Farmer, why on earth do you invest in it? Many big companies have thousands of Mr John Farmers as shareholders. Despite receiving pitiful returns on their money these shareholders remain loyal. And in my opinion they should not.

Ignorance, comfortable familiarity with big household names, sheer inertia and the prospect of wine and canapés at the annual general meeting, all these have something to do with this show of faith. But private shareholders think it is good to be loyal. They get some grim satisfaction out of sticking with a company through thick and thin. However dark and long is the tunnel, they believe that there must be a light at the end.

Frankly I don’t understand this attitude. When I invest in a share, or recommend one to readers of Red Hot Penny Shares, it is because I believe that it can grow and prosper and that it could make its shareholders I will be the first to admit that they do not all work out. But investment should be an active hunt for profit. Not an example of British stoicism and a belief that ‘something will turn up’. For shareholders in Cable & Wireless Worldwide, to name just one large and dysfunctional company, I see no reason why this show of fortitude will ever be rewarded.

So there are lessons to be learnt from the current market chaos – and the news isn’t all bad.

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