Penny stocks – Things you must know before investing

Penny stocks are those common stocks that trade at a very low price in the market. They cost as much as a few pennies. In the market, shares that trade below the price of Rs 5 are considered to be penny stocks. But in some cases, it includes those shares that are priced below Rs 10.

There is no specific official definition or hard and fast rule to determine penny stocks. Due to small market capital size, it’s referred to as micro-cap or nano-cap stocks.

First, we will discuss a few important characteristics of penny stocks, and then we will quickly dive into to know whether investing in penny stocks is right for you and why people invest in it. 

The most common characteristics of penny stocks are:

  • Very low/small market capitalisation as they trade below Rs 5 / Rs 10 per share.
  • Fluctuate tremendously in price in a very short period of time
  • Little to no profits
  • Mostly illiquid
  • Highly risky because of lack of liquidity
  • Very speculative in nature
  • Minimal operation

In general, penny stock companies claim to have products and a management team, but they don’t generate any money. These companies often headed for bankruptcy due to a highly over-leveraged balance sheet. 

Shares of these companies are popular among speculators. These speculators get investors excited to buy penny stocks and after buying they dump their own shares for a quick profit.

Why people invest in penny stocks

Price of penny stocks fluctuates wildly in a very short period of time. In a 4-5 trading session, the price can go from Rs 3 to Rs 6 or Rs 1 to Rs 2. Due to this reason, a lot of people when starting out on investment tend to go in for these stocks to double their investment and then finally realise that these are worthless.

One of the biggest problems in buying and selling a penny stock is that, if you bought it for Rs 2 and want to sell it at Rs 4, then you might not be able to execute your trade in the absence of buyers even though the price in your brokerage account showed up as Rs 4. Your sell order at Rs 4 will not get executed and you will be sitting on that penny stock day after day.

With an investment of Rs 20,000, inexperienced investors think they can purchase 10,000 shares of the 2 rupee penny stock with an understanding that by buying more number of shares of a company, they will earn more profit instead of investing in a stable company’s stock with a market price of Rs 1,000, in which they can get only 20 stocks. It happens because these beginners do not understand the difference between price and value. 

People in the stock market think that these stocks have the potential of turning into a multi bagger stock. As a human being, people expect 100% return quickly as the stock is trading so low that it can’t go further down. You have to be very careful as these stocks can wipe out your entire investments in a single trading session.

Does it mean that you should avoid penny stock? Well, the answer to this is it depends. Many investors consider penny stocks as a high risk, high reward investments. There are many excellent companies traded for pennies for some time. If you go by the definition of penny stock, then you will find that Kotak Mahindra Bank, FORD motor company, eicher motors, titan and UPL, once upon a time were in the penny stock category. But these stocks are now multi baggers. However, it does not mean that all penny stocks should be multi baggers. To get better returns in the long-term, we suggest you go for cognitive investing.

In cognitive investing, you need to isolate the current market conditions and predictions by market gurus. Instead you need to pay attention to the stock’s valuation, business model, growth potential, management’s asset allocation etc. This means you are buying business not stocks. Share price of quality stocks move with increase in revenue, increase in profitability, growing in size and by capturing market share. If you find high quality stocks trading at a low price, you can multiply your investments when the share price moves higher.

Many market participants often ask “what is the best penny stock to buy”. Answer to this question is very simple: buy those penny stocks which have significant upside potential and limited downside risk. Share prices will go up if the company has a proven management team, improving financial position, growing market share, improving financial ratios and good products and services to dominate industry.

It’s very easy to lose money by investing in a penny stock. However if you have done proper homework on the company before investing and your share does begin to move, then it can be a 100 or 1000 baggers for you.

Pros and Cons of Penny Stocks

There are different sides to penny stock investing. Like any other type of investment, investing in penny stocks has its own advantages as well as disadvantages. 

Advantages

  • Per share price of the stock is very low due to which you can hold a good percentage of ownership in the company.
  • There can be excellent quality companies trading for pennies which can become big winners of tomorrow.
  • You can buy many stocks at a time without worrying about cost or capital.
  • Chances of higher return if these stocks started moving up.
  • Potential to invest in new and exciting companies.
  • Investors can make big returns in a short amount of time.

Disadvantages

  • Penny stocks are risky purchases, more volatile and represent those companies which can be derailed anytime. Before getting into these companies you must take the amount of risk into account. These companies may get suddenly delisted.
  • To make an informed decision, you will not find enough market available information and details about their operation as media agencies and analysts don’t pay much attention to these companies.
  • Due to unproven management, product and industry, penny stock companies’ future operations are in doubt.
  • These cheap securities are highly speculative and extremely low in quality.
  • Shares that have fallen to penny-stock status could get delisted or shunned by the investment community and come under regulatory scrutiny.

As discussed above, there can be certain quality companies trading in the penny stock category. If you can find those companies, then it can be a 100/1000 bagger for you. Here are certain guidelines to pick a winning penny stock for your portfolio.

  • Focus on past, present and future earnings of high quality penny stocks.
  • Evaluate the upside potential of the penny-stock.
  • Don’t trust any stupid newsletters or recommendations.
  • Avoid low quality companies with unproven management, product and industry.
  • Study the industry in which the company operates, its history and reputation of those who manage it.
  • If you have selected one or two quality penny stocks, then don’t invest a large amount in it. Out of your total diversified portfolio, you can invest in one or two quality penny stocks after proper homework.Diversify your portfolio by keeping 5% to 10% of your overall portfolio in penny stock based on your risk tolerance.

Penny stocks are too risky, and not appropriate for beginners.

Pump-and-Dump Scheme

If you are into stock market, then you must have received emails or heading in newsletter quoting “hot penny stocks that’s going to make you rich.” You need to be very careful as it can be a part of the most popular Pump-and-Dump scheme strategy.

Pump-and-Dump schemes are common in penny stocks. In a Pump-and-Dump scheme, fraudsters recommend penny stocks by sending SMS, emails, phone calls or by recommending through newsletters to inexperienced investors based on false and misleading statements. 

Based on the recommendation, people start buying the stock, pumping the price. Once stock has reached a certain inflated price, these perpetrators sell or dump their shares for a huge profit, causing the price to drop dramatically. Due to the pump-and-dump scheme, new inexperienced investors always lose their money.

Buying penny stock is very risky. All these stocks traded at a low price for a reason. Therefore, we suggest you do your homework before getting into penny stocks. Don’t take risk by putting money kept for emergencies, retirement or other unavoidable circumstances.

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.