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Jim Nelson is the managing editor of the Penny Sleuth e-letter, a free daily newsletter that focuses on small-cap, options and high-growth opportunities. Along with analysts Greg Guenthner and Jonas Elmerraji, Jim is an editor of Penny Stock Fortunes, a premium small-cap newsletter. Jim is also the editor of Lifetime Income Report, Agora Financial's new income investment advisory that launched in February.

I recently sat down with him to give us a little perspective on the small-cap market these days. As a big fan of small-cap stocks myself, I'm always interested in hearing what other small-cap experts have to say. Plus he'll share with you a few of the stocks he's watching now. Here's what he had to say…

Ian: Jim, first and foremost, "penny stocks" are one of the most misinterpreted investments on the market. How do you define them?

Jim: Ian, the term "penny stock" is misleading to many investors. Basically, we consider penny stocks to be any small caps that trade under $10 per share. But share price isn't the most important thing here — total market capitalization is.

We define a small cap as any stock whose total market cap rings in at $1.5 billion or less. While those cutoffs can be subjective, those are pretty common ranges for penny stocks to trade in.

Ian: Some investors tell me they think penny stocks are risky. What's your response to that?

Jim: Risk is a very important question when it comes to penny stocks. You see, small companies behave very differently than larger companies like GE or Microsoft. That said, the stocks we look at are real companies with growing, sustainable businesses — while they may be subject to somewhat bigger price swings than blue chip stocks, they also bring the potential for much bigger profits because most of their growth is ahead of them.

The vast majority of small caps we look at trade on major exchanges like the NYSE or Nasdaq… only a select few carefully vetted over-the-counter stocks reach our readers.

Ian: How are penny stocks performing in this market?

Jim: For the most part, penny stock performance mirrors the rest of the market. But what's unique about penny stocks is the fact that historically, they lead the charge out of recessions and into prosperity.

That changeover is something we've seen a lot of — probably more than many blue chip investors — in 2009… While we generally focus on broadening Penny Sleuth readers' "investment toolboxes" in our free daily issues, we do occasionally talk about specific small-cap opportunities in the Sleuth. Two of our most recent mentions were Xinhua Finance Media (Nasdaq:XFML) and GP Strategies (NYSE:GPX) — these penny stocks brought in returns of 45% and 77%, respectively, during a rough time for the rest of the market.

And in Penny Stock Fortunes, our premium newsletter, in which we recommend small-cap plays every month, we've closed gains as high as 279% already this year.

Ian: What's your fundamental strategy right now?

Jim: With an economy that's still far from recovered and credit that's hard to come by, three of the biggest metrics we've been targeting have been a strong balance sheet, positive free cash flow and a bargain-priced price-to-book ratio.

In this climate, we're after penny stocks that can thrive and not just survive this economy… that's why a solid balance sheet position and positive free cash flow are so important. We've seen scores of businesses deemed "too big to fail" collect emergency funds from Uncle Sam to keep from going belly up; penny stocks don't have that luxury. That makes ensuring that a small-cap company can pay its bills on the top of our priority list.

And an attractive price-to-book ratio shouldn't be discounted either… when the stock market "fell through the floor" in 2008, it dragged just about every publicly traded company with it — whether or not the company was overvalued at the time. In the aftermath, we've found that there are many companies trading vastly below their fair values. That's true even today. We've been lucky enough to snap up many beaten-down companies early enough that we were left with respectable gains after more mainstream investors realized the value proposition that was going on at the time.

Ian: You said that penny stocks historically lead the way out of recessions… Where will this recovery come from?

Jim: It's funny you mention that — a few months back, we set out to create a small-cap recovery index to determine exactly which industries were leading the charge to recovery, as well as how far along recovery actually is.

The project is a complicated one. It involves the selection of hundreds of stocks and additional metrics like unemployment and savings rates. Once these benchmarks are selected and compiled, we will begin to see a picture developing that will reveal investor sentiment and market performance. Eventually, when enough data are compiled, we will have a more accurate picture of where the market is headed. 

Ian: More specifically, into which industries are you putting your money?

Jim: Two industries sure to set fire to the market over the next few years are "green tech" and telecommunications. Green tech stocks are, obviously, on every investor's mind — especially people who put their money in small-caps. Finding the right ones is the hard part.

For instance, Maxwell Technologies (Nasdaq:MXWL) popped on our radar awhile back. We got in while it was still trading as a penny stock. We've since booked our gains on that one, but we're always watching in case we get a second chance to act.

Telecoms, at least in emerging economies, have the benefit of billions of potential customers and fat profit margins. Just look at Nortel Inversora (NYSE:NTL). This Argentinean telecom is growing its top line in a country where millions of new Internet and phone users are subscribing every year.

Ian: Say someone who had never invested in penny stocks before approached you. What would your first piece of advice be?

Jim: You need a discount broker you can trust — one that won't charge you an arm and a leg to buy and sell stocks. If you are paying $3 per share and getting charged $50 for each trade, you're putting yourself in a huge hole from the start. There are plenty of discount brokers, but you need to know what exactly you're looking for. We keep our Penny Sleuth readers up-to-date on which brokers are out there and of any changes to their fee schedules.

Jim, thanks for spending some time with us today and sharing your thoughts on penny stocks with Daily Profits readers.

Jim Nelson is the managing editor of the Penny Sleuth e-letter, a free daily newsletter that focuses on small-cap, options and high-growth opportunities. Delivered at least five times per week, Penny Sleuth shows readers everything from macroeconomic trends and technical analysis to individual penny stock and option investing ideas.

Click here to start your FREE Penny Sleuth subscription today!

Small-cap stocks cascaded lower Wednesday as a spree of soft earnings reports and a dreary outlook as the economy veers into recession took a toll on the market. The Russell 2000 (NYSE:IWM) closed down 28.85, or 5.43% at 501.97. This was the second-lowest close in five years, and both of those closes have taken place within the last three weeks. This also marked the fifth-largest one-day decline of the year. The Russell is now down 33.4% for 2008, while the Dow is off 36.36% and the S&P 500 is down 38%. Although the Russell and Dow averted sinking to fresh closing lows for the bear market collapse, the S&P 500 and Nasdaq 100 did set new closing lows.

Although there were isolated upside earnings surprises as the market digests a flood of key reports this week, the overriding investor sentiment right now is that the results are relatively soft and were already watered down to begin with (from an expectation standpoint). What’s more, concerns that consumer spending and a global growth stall will pinch corporate profits even more in the months to come clearly had a negative impact on stocks. Even the companies with solid profits were wary of the operating environment heading into 2009. Even McDonald’s Corp. (NYSE:MCD) — which by most accounts posted impressive results — was unable to post a positive close for the day.

Another theme that remained at play was the wipeout in commodity valuation and the impact that had on stocks with commodity themes. Commodity firms dominated the list of worst performing sectors today, paced by metal and mining shares, coal stocks, oil and gas drillers, aluminum and gold. Other sectors taking a body blow today included motorcycle manufacturers, restaurants, tobacco companies and internet retail stocks. On a depressing side note, there wasn’t even one broad S&P sector group in the plus column late this afternoon.

The slide in commodities was reflected by a huge decline in the Commodity Research Bureau Index, which tumbled 4.5% to the lowest point since August . . .

Small-cap stocks remained solidly lower into midday trading, pressured by concerns that the latest batch of quarterly earnings were painting a difficult canvass moving toward 2009. Even the bullish earnings surprises seem tainted by worries that a prolonged recession will pull down corporate profitability for some time. At 12:47 p.m. ET, the Russell 2000 (NYSE:IWM) was down 12.71, or 2.39%, at 518.10.

At the lows today, the Russell was testing minor trendline support drawn off the recent lows. That line also forms the bottom edge of a pennant pattern, and a breakdown through today’s lows would suggest further downside probing toward that major low. Below today’s low at 514.42, there is very little chart support until we get close to the “figure” point at 500, which stands as another important test for any bulls who want to find value at the depressed levels.

As for the latest batch of earnings today, there were red flags from nearly every sector, with pharmaceutical firm Merck & Co. (NYSE:MRK) projecting a very cautious outlook. ConocoPhillips (NYSE:COP) was down about 6%, warning that exploration and output would slide and airplane maker The Boeing Co. (NYSE:BA) was down about 6.5% as a strike hurt profits.

The biggest declining sectors this morning came from coal, motorcycle manufacturers, metal and mining stocks, oil and gas drillers, aluminum, gold stocks and casinos. For the second day in a row, commodities were getting nailed as the prospect of global slowing takes a toll on physical markets and the companies that deal in those products. The Commodity Research Bureau Index of 19 physical markets . . .