Penny stocks refer to companies trading with a market-cap of less than £100m and a share price below £1. Typically, these types of businesses have a higher risk level than large-cap shares. The share price can be very volatile, which can put some investors off. However, volatile can also mean jumping higher, which is what I believe could happen here.
With a current share price of 23p, Mercia Asset Management (LSE:MERC) has a market-cap of £98m. The UK-based private equity firm invests in various ventures and debt solutions.
It mostly targets new technology, or tech innovations, for funding. For example, it has a stake in nDreams, a world-leading VR game publisher and developer.
As a private equity company, the bulk of deals are with firms not listed on the stock market. Given that Mercia isn’t targeting large, established tech companies, most are likely to be privately held.
The aim is for Mercia to buy a share of a business, help it to grow, and then sell the stake further down the line. This could be to another investor or via an initial public offering (IPO). As a result, it hopes to make a profit.
Why I think there’s large potential
In July, the business released its report for the last financial year. It had £1.4bn of assets under management, up from £959m the previous year.
Revenue jumped from £12.7m to £25.9m, with the team expanding from 93 to 142. These are all positive signs of a firm with momentum. The fact the business has around 570 investments in its portfolio makes me comfortable it’s diversified in risk exposure.
The main reason I believe the stock’s cheap is based on the outlook. Profit before tax was £2.4m, but it expects that figure should average around £20m over the next three years.
The current price-to-earnings (P/E) ratio is 34, which isn’t exactly cheap. But let’s say earnings per share is around 10x in the coming few years. In line with the increase in profits, and the share price that stays at a similar level, this would make the stock very undervalued as we stand today.
Points to consider
Another factor I think is key is its tech focus. This is the future. Even though buying an individual tech name can be risky, buying shares in Mercia is much less risky. It holds so many different stocks that even if just a couple really take off, the benefit to Mercia could see the share price rocket.
One concern I do have is the concentrated exposure to UK companies. I’m also conscious of the state of the economy and how this might keep a lid on potential growth for young tech companies. Finally, being a penny stock is always going to put off some investors.
Yet, on balance, I think the stock looks cheap, based on future earnings. And if its outlook is achieved and some investments take off, this might not be a penny stock forever. Therefore, I think investors who understand the risk might do well to consider buying the stock.
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Jon Smith 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.
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