My first introduction to the stock market was when I started my first job, and one of my new colleagues asked me if I wanted to join their penny shares club.

He told me all about finding multibaggers and getting rich quick. Shares down in pennies must have more potential than stocks that have already risen, right?

It sounded like they were buying fallen shares simply because they’d fallen, and hoping. I politely declined. Was I right?

Low-price shares

I’m sure I was right not to join them. But I’m also convinced it’s wrong to simply ignore penny shares because of the potential danger.

Carefully chosen with an eye on valuation and looking to the long term, I’d say penny shares can potentially be as profitable as any other.

Let’s look at one of my favourites, Michelmersh Brick Holdings (LSE: MBH). It’s technically a penny stock with its 97.25p share price below the 100p cutoff. And the market cap of £91m is within the usual £100m limit.

Return to growth

It’s been a lot lower in the past, though. Back in 2009, Michelmersh shares dipped to around 10p, down near the bottom of the penny share barrel.

But all that really matters to me is valuation.

Anything related to construction has been through a few years of pressure. And Michelmersh is expected to record a fall in earnings per share (EPS) this year.

It still puts the shares on a modest price-to-earnings (P/E) ratio of 13.5, though. And that could drop to just 10 on 2026 forecasts.

Cash flow

There’s still plenty of risk here, as we don’t know when construction will pick up. And if earnings and cash flow don’t go as expected, the dividend could come under pressure.

Oh, there is a dividend, forecast at 4.6%.

But, cash flow was poor in the first half, down 88% to only £0.9m. It’s still positive, though. And hopefully this should be the weakest year.

The company reached the halfway point with net cash. It was only £4.1m, down from £11.8m a year previously. But at least we’re not looking at added debt risk.

Good penny shares

This is just one example, and I think it highlights the things I look for when I try to reduce the risks with buying penny shares.

Firstly, I really want to see profit. Some currently loss-making firms might be set for a rebound and a strong future. But losses just add to the danger.

I like decent cash flow too, and that’s possibly Michelmersh’s biggest weakness at the moment. Still, a well-covered dividend is a good sign.

I also want to see a simple business in a market with good long-term potential. And I’ll keep away from anything heavily affected by, for example, retail sentiment.

Dangers

I don’t want to sound like I think penny shares are all sweetness and light. No, I always think back to a highly speculative one I once considered buying at about a penny. How much more could it fall? Today it’s about 96% lower.

When it comes to penny shares, I suggest being especially wary of ‘jam tomorrow’ ones.