In this article, we will take a look at the 12 best quality penny stocks to buy. To see more such companies, go directly to 5 Best Quality Penny Stocks to Buy.

Finding quality penny stocks has always been difficult. It’s like finding a needle in the haystack. There are thousands of penny stocks and a majority of them might fail and go to zero. Scams, pump and dump schemes, liquidity problems and lack of any business model are just a few of the long list of problems that keep an average, risk-averse investor at bay from penny stocks. Yet in these penny stocks are hidden the gems of the future. Small companies working on long-term growth catalysts, products and services provide investors a chance to become wealthy by investing in the stock market, something that’s becoming harder by the day. A report by Westcore Funds sheds some light on the importance of investing in quality penny, or micro-cap stocks, for long-term gains. The report said that micro-cap stocks usually remain under the radar because Wall Street analysts are not interested in covering them. The report cited a data point says on that on average each large-cap stock is covered by 26 analysts while on average each micro-cap stock is covered by two analysts.

The report said that this huge difference in analyst coverage of two categories creates a lot of mispriced stock opportunities in the micro-cap sector which could be used by investors. The report also cited data which shows the historical outperformance of micro-cap stocks. From 1992 to 2015, the Dow Jones U.S. Micro Cap posted a whopping 1199% in returns on a cumulative basis, compared to 696% for the S&P 500 index

The report also debunks a commonly held thought that micro-cap stocks are risky because of their liquidity issues and trading volumes. The report said that Alpha, which is a measure of risk-adjusted performance, “is actually higher for micro- caps than it is for other equity asset classes when compared to the overall market.”

But even if we acknowledge the fact that risks are higher for micro-cap companies, there are some research reports which show that these risks are more than offset by returns posted by these micro-cap companies over longer periods of time. For example, a report from Acuitas Investments shares some interesting data points from research done by Eugene Fama and Kenneth French.  The report shares some charts on stock volatility of different market cap categories for 25, 50, and 75 years.

Acknowledging the caveats linked with micro-cap stocks or penny stocks, it’s a fact that if one manages to find quality penny stocks with high growth potential, they can offer huge changes of wealth creation. For example, the Acuitas Investments report highlights some of the important fundamental differences of micro-cap stocks and large-cap stocks. The report said that micro-cap stocks trade at roughly half the price to book as large cap stocks. The biggest reason behind this low valuation, according to the report, is that these companies receive little or no attention from institutional investors. The report said that the valuation of micro-cap stocks is lower than large-cap companies when seen in all key metrics, including Price/Sales, Price/Cash Flow, and naturally the Price/Earnings ratio. However, a key caveat here is that most of the penny stocks or micro-cap stocks have negative earnings. These companies are still burning a lot of cash and funding their operations that are expected to bear fruit in the long run. On the other hand, micro-cap companies have higher sales growth, better than large-cap companies. The report said that on average the micro-cap index has a sales growth of 18.1%, better than large-cap’s 11.2% sales growth.

Gains for Those Who are "Willing to do the Work"

The report then reiterates the simple fact which is perhaps present in every micro-cap stock investing primer. Potential gains in the micro-cap universe are for those are “willing to do the work.” You will find tons of analyses on Apple, Microsoft, Meta Platforms and other major companies. But you wont find much analyst coverage on penny stocks in the mainstream media. Are you ready to dig deeper to find the real quality penny stocks currently trading in the market? It’s easier to say yes than executing the long, tiring process of finding quality penny stocks. But why not see what the investing gurus have been doing in this area? That’s why in this article we decided to list down some quality penny stocks bought by hedge funds.

Photo by Nicholas Cappello on Unsplash

Our Methodology

For this article we first used a stock screener to find companies that are profitable, trading under $5, have sales growth of over 5% over the past five years, have positive EPS growth (quarter over quarter) and positive sales growth (quarter over quarter). From the resultant list of stocks we picked the penny stocks with the highest number of hedge fund investors. We gauged hedge fund sentiment for these stocks using Insider Monkey’s proprietary database of 943 hedge funds. This way, the stocks in this article are the best quality penny stocks to buy according to hedge funds.

Best Quality Penny Stocks to Buy

12. Great Elm Group, Inc. (NASDAQ:GEG)

Number of Hedge Fund Holders: 7

Waltham, Massachusetts-based Great Elm Group, Inc. (NASDAQ:GEG) is engaged in durable medical equipment and investment management businesses.

A total of 7 hedge funds tracked by Insider Monkey had stakes in Great Elm Group, Inc. (NASDAQ:GEG). The biggest stakeholder of Great Elm Group, Inc. (NASDAQ:GEG) was Matthew Drapkin and Steven R. Becker’s Becker Drapkin Management which owns an $8.3 million stake in the company.

11. Great Elm Group, Inc. (NASDAQ:GEG)

Number of Hedge Fund Holders: 7

Medical equipment company Great Elm Group, Inc. (NASDAQ:GEG) ranks 11th in our list of the best quality penny stocks to buy according to hedge funds. Earlier this year, Great Elm Group, Inc. (NASDAQ:GEG) sold Forest, one of its subsidiaries, to JPMorgan. The first tranche of the deal raised $18 million from the sale of 61% of the common equity. In February Great Elm Group, Inc. (NASDAQ:GEG) posted results for fiscal Q2. GAAP EPS in the period came in at $0.74. Revenue in the quarter jumped 84.3% year over year to $1.88 million.

As of the end of the first quarter of 2023, 7 hedge funds tracked by Insider Monkey had stakes in Great Elm Group, Inc. (NASDAQ:GEG). The biggest stakeholder of Great Elm Group, Inc. (NASDAQ:GEG) was Matthew Drapkin and Steven R. Becker’s Becker Drapkin Management which owns an $8.3 million stake in the company.

10. Smart Sand, Inc. (NASDAQ:SND)

Number of Hedge Fund Holders: 8

Texas-based Smart Sand Inc. (NASDAQ:SND) is engaged in the excavation, processing, and sale of sands or proppants for use in hydraulic fracturing operations in the oil and gas industry. In May Smart Sand Inc. (NASDAQ:SND) posted Q1 results. Smart Sand Inc. (NASDAQ:SND)’s revenue in the period jumped about 98% year over year.

Insider Monkey’s database of 943 hedge funds shows that 8 hedge funds had stakes in Smart Sand Inc. (NASDAQ:SND) as of the end of the first quarter of 2023.

9. Ring Energy, Inc. (NYSE:REI)

Number of Hedge Fund Holders: 9

Oil and gas exploration company Ring Energy, Inc. (NYSE:REI) ranks 9th in our list of the best quality penny stocks to buy according to hedge funds. Ring Energy, Inc. (NYSE:REI) recently said it agreed to buy the Central Basin Platform assets of Founders Oil & Gas IV located in the Permian Basin for $75 million in cash.

Ring Energy, Inc. (NYSE:REI) in July also announced a $25 million net reduction in borrowings from its $600 million senior revolving credit facility during the second quarter. A total of 9 hedge funds tracked by Insider Monkey were long Ring Energy, Inc. (NYSE:REI). The biggest stakeholder of Ring Energy, Inc. (NYSE:REI) was John Overdeck and David Siegel’s  Two Sigma Advisors with a $3 million stake in the company.

8. LexinFintech Holdings Ltd. (NASDAQ:LX)

Number of Hedge Fund Holders: 9

China-based LexinFintech Holdings Ltd. (NASDAQ:LX) is on a tear in 2023, gaining about 44% year to date. As of the end of the first quarter of 2023, 9 hedge funds in Insider Monkey’s database had stakes in LexinFintech Holdings Ltd. (NASDAQ:LX). The most significant stakeholder of LexinFintech Holdings Ltd. (NASDAQ:LX) during this period was DE Shaw with a $2.9 million stake in the company.

7. Wipro Limited (NYSE:WIT)

Number of Hedge Fund Holders: 10

IT services and consulting firm Wipro Limited (NYSE:WIT) is one of the top quality penny stocks to buy according to hedge funds. Insider Monkey’s database of 943 hedge funds shows that 10 funds had stakes in Wipro Limited (NYSE:WIT). The biggest hedge fund stakeholder of Wipro Limited (NYSE:WIT) during this period was Ben Levine, Andrew Manuel, and Stefan Renold’s LMR Partners which had an $11 million stake in the company.

Last month, Wipro Limited (NYSE:WIT) said it plans to spend $1 billion to advance AI capabilities over the next three years.

In July, Wipro Limited (NYSE:WIT) posted Q1 results. GAAP EPS in the period came in at $0.06. Revenue in the quarter jumped 6% year over ear.

6. PaySign, Inc. (NASDAQ:PAYS)

Number of Hedge Fund Holders: 12

PaySign, Inc. (NASDAQ:PAYS) is a prepaid cards and payments processing company that mostly serves the plasma industry.

In June, PaySign, Inc. (NASDAQ:PAYS) completed an issuer certification and connection with Mastercard (NYSE:MA). PaySign, Inc. (NASDAQ:PAYS) jumped about 1.2% on the news.

As of the end of the first quarter of 2023, 12 hedge funds tracked by Insider Monkey had stakes in PaySign, Inc. (NASDAQ:PAYS). The biggest stakeholder of PaySign, Inc. (NASDAQ:PAYS) during this period was Joseph P. Colmery and Steven J. Didion’s JCSD Capital with an $886 million stake in the company.

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Disclosure: None. 12 Best Quality Penny Stocks to Buy is originally published on Insider Monkey.