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About to Buy Penny Stocks? Look at These 3 Companies First

Matthew DiLallo, Neha Chamaria, and Maxx Chatsko, The Motley Fool

The upside potential for penny stocks looks so tempting. A stock trading for a few pennies only needs to rise by a couple of nickels to deliver a big-time return. That could turn a small investment into a massive windfall, which is why penny stocks woo so many investors.

The problem with most penny stocks, however, is that fraudsters can easily manipulate them so that they make money at the expense of other investors. That's why we believe investors should avoid them at all costs. Instead, we prefer that you buy stocks of actual companies with real growth prospects since they could produce outsize returns.

Three high-upside options that these Motley Fool contributors think offer a far greater probability of earning fat returns than a penny stock are pharmaceutical company Axsome Therapeutics (NASDAQ: AXSM), oil and gas producer Chesapeake Energy (NYSE: CHK), and wind blade maker TPI Composites (NASDAQ: TPIC). Here's what we find intriguing about these high-risk, high-reward stocks. 

A man drawing a rising chart of dollar signs on a green chalkboard.

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High risk, high reward

Maxx Chatsko (Axsome Therapeutics): Any individual investor (mistakenly) dreaming of striking it rich with penny stocks should instead consider Axsome Therapeutics. The pharmaceutical company has scratched and clawed its way from obscurity and a lowly $60 million market cap at the end of 2018 to a market valuation of over $800 million today. While it's a risky bet, there could be plenty of gains left for opportunistic investors. 

Axsome Therapeutics has caught the eye of Wall Street since announcing solid clinical results for its lead drug candidate, AXS-05, in major depressive disorder (MDD). The results from a phase 2 trial were so impressive that the U.S. Food and Drug Administration granted the experimental treatment Breakthrough Therapy Designation, which means the mid-stage trial results will be treated as if they were compiled from a phase 3 trial when the new drug application is submitted. 

The company is still going to run a phase 3 trial in MDD to play it safe, but that's less than the two late-stage trials previously planned for that indication. Axsome Therapeutics is also conducting a phase 3 trial with AXS-05 in treatment-resistant depression (TRD), which will likely have results submitted to regulators along with the MDD batch. 

The market opportunity for new and effective depression treatments is enormous, as evidenced by the $9 billion market cap of Sage Therapeutics, which recently earned marketing approval for its first depression drug product and is hoping to bring several more to market. However, if AXS-05 proves successful, then Axsome Therapeutics could have the edge. That's because its drug candidate is a simple formulation (a combination of a smoking cessation drug and the main ingredient in cough syrup, believe it or not) that can be taken orally and manufactured with ease. The first product from Sage Therapeutics must be injected, although oral formulations are now being tested.

Axsome Therapeutics also has a drug candidate, AXS-07, being evaluated as a treatment for migraine in a phase 3 trial. That means the company expects to have data from three late-stage clinical trials by the end of 2019. If earlier results don't hold up, then owning shares could be a disaster. But if the pipeline continues to shine, then investors will be handsomely rewarded.

A high-risk, high-reward oil stock

Matt DiLallo (Chesapeake Energy): With its shares currently around $2 apiece, oil and gas producer Chesapeake Energy will undoubtedly appeal to investors who are interested in a low-priced stock. More importantly, however, unlike many penny stocks, Chesapeake Energy has a sound underlying business.

The oil and gas driller controls high-quality drillable land across many of America's top shale plays. That resource base -- which the company recently boosted with a needle-moving acquisition -- has it on track to grow its oil production by 32% this year. Further, the company sees its oil output increasing another 29% next year, which would effectively double its adjusted production from 2018's stand-alone level.

The problem with Chesapeake Energy -- and the reason it has a low share price -- is that it ended the first quarter with nearly $10 billion of debt on its balance sheet. That pushed its leverage ratio up to around 4.0 times debt to EBITDA, which was twice its targeted 2.0 times level. While the company's oil-focused growth plan has it on track to reduce leverage to about 2.8 times by the end of next year, it needs oil prices to cooperate to achieve that plan.

Because of its debt level, oil prices can have a significant impact on Chesapeake Energy's stock price. This year, for example, Chesapeake Energy's stock soared more than 50% as oil prices rebounded from 2018's late-year plunge. However, it has since given up all those gains and then some as it's now down about 8% after crude prices crashed into another bear market. If oil prices rebound again, Chesapeake Energy's stock could soar, which makes it an appealing option for investors seeking significant upside. However, if crude keeps falling, Chesapeake's stock will likely tumble even further, which is why investors need to tread carefully with this oil stock.

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Image source: Getty Images.

Try throwing caution to the wind 

Neha Chamaria (TPI Composites): The strongest argument against buying penny stocks is the risks they carry, which could range from business and industry risks to thinly traded share volumes. Where things stand now, TPI Composites might seem like a risky proposition given several unanticipated recent challenges that forced the composite wind blade manufacturer to slash its full-year earnings guidance. Yet, TPI shares could prove richly rewarding in the long run if things fall into place as the company anticipates.

You see, TPI doesn't have to worry about demand. In its first quarter, the company billed for 662 wind blade sets, or roughly 16% more units year over year. TPI's average realized sales price is also visibly trending north for some quarters now. Globally, wind remains the largest "non-hydro renewable technology," with power generation growing 12% in 2018, according to the International Energy Agency. TPI is a leader in wind blades manufacturing and counts the world's largest wind turbine companies among its customers.

TPI's problems, therefore, stem from issues other than demand, such as a customer bankruptcy and a labor strike at its Matamoros facility in Mexico in the first quarter. The impact of the latter, in particular, could last through the year in the form of limited production and higher costs. Mexico contributed nearly 26% to TPI's sales in fiscal 2018 with Matamoros having just started production last year, mainly of blades for TPI's largest customer, Vestas.

Amid the headwinds, President Trump's recent decision to not impose tariffs on Mexican imports comes as a relief for TPI. For now, management is confident that it will double 2018 revenue to more than $2 billion by 2021. TPI shares, therefore, have a strong chance to make up for recent losses and some beyond 2019 if the company can swing back to profitability next year and inch closer to its 2021 goals.

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Matthew DiLallo has no position in any of the stocks mentioned. Maxx Chatsko has no position in any of the stocks mentioned. Neha Chamaria has no position in any of the stocks mentioned. The Motley Fool recommends TPI Composites. The Motley Fool has a disclosure policy.