I have often been asked by even educated investors and the typical trader investor who wants to make a fast upside, is that, is it worth buying penny stocks because there are dirt cheap. My answer is NO. There are several examples of penny stocks like King Fisher Airlines, Lanco Infra, GTL, Moser Baer, Glodyne Techno, etc which were the stock market “stars” earlier.
It is more important to consider the fundamental attributes of such stocks and the underlying company.
A penny stock has a low price and low market capitalization. It isn’t necessary that these stocks trade every day. Often they are part of the trade to trade segment. What this means is that they have very low liquidity and the difference between the bid price (buy price) and ask price (sell price) can potentially be very large.
So transactions are done over the counter rather than through an exchange.
Thanks to the lack of liquidity, speculative trading in such stocks picks up and hence, these are considered risky. With regards the underlying company, usually it is a small-cap company with limited business and growth prospects.
The company behind such stocks usually has little to show by way of financial health and management strength. But often these companies are in news and stocks get a boost from that.
Why is it attractive?
The sheer number of penny stocks in the market makes them hard to miss. In the Bombay Stock Exchange (BSE), there are around 725 stocks trading below Rs.10 and around 1171 below Rs.20. On the National Stock Exchange, the number is 355 and 189, respectively.
The main reason for buying a penny stock is that an investor can get a large number of shares at a small total value. For example, if a company’s market price is Rs.9, you can buy 1,000 shares for just Rs.9,000. On the other hand, if you were to pick a bluechip company with a current market price of, say, Rs.1,800, you would only get five shares. The hope is that the penny stock will give superior returns as the stock price is low; with 1,000 shares, you can benefit a lot.
In reality, stocks that are backed by companies with good fundamentals, financial health and strong management are the ones likely to give good returns in the long run, no matter what the share price is.
So don’t get fooled into buying penny stocks just because the price is low. Also, keep in mind that not all low-priced stocks are poor quality, so, do your basic research on financials and management before buying or rejecting a stock.
“Buy low and sell high” is the ultimate winning strategy in the stock market. But some investors take this saying literally and buy very low-priced stocks. Since the market cap here is low, they are easily manipulated by operators who lure unsuspecting investors and dump worthless shares on them.
They first create a buzz around a stock, indulge in circular trading to push up the price, and then nudge investors to buy at high prices
I have a friend who bought a lot of Birla Power Solutions and Jupiter Biosciences in 2009. These were really hot penny stocks in late 2008. Let me tell you that he regrets his decision now. They have gone way down.
FALLING INTO VALUE TRAPS
Buying a stock just because the price has fallen 50% from its peak is not always a good proposition. You may end up in a value trap. Investors who go hunting for bargains in the initial phase of a bear market also get into the value trap.
They compare the current price and PE multiples with the earlier peak and start buying because the stock is available ‘at a discount’. However, the price may continue to fall and losses could mount.
What should a smart investor do –
Most all-time peaks are scaled during extreme euphoria in the market and, therefore, do not represent the real value of that stock. Similarly, it is not fair to judge the current valuation of a stock by comparing it with its all-time high valuations.
Instead, compare the current valuation with average valuations for the past 5-10 years. You also need to know why the valuations came down. Avoid buying if the fall is due to a decline in growth rates or if the industry is in trouble. Stocks with corporate governance issues usually quote at cheap valuations, buying them is not a great idea.
However one can go wrong even with the blue chips. Small investors often get carried away by the market euphoria ignoring the ‘value’ of the stock. A good stock at a very high price is not a good investment.
Sound research and prudent diversification are two weapons of an investor. By researching thoroughly, you reduce the probability of big mistakes. Even if one of the stocks in your portfolio goes belly up, others should compensate your returns.
One of the key financial inputs which make a stock a great investment is looking at the dividends paid and the RoE generated. This has been empirically proven that if both these are strong then small caps eventually become bluechips.
In conclusion, I would like to add that investing in penny stocks is like throwing your hard earned money in a bottomless pit where there is no respite, so beware of Penny Stocks and invest wisely and smartly.
Chief Investment Officer @ Precision Investment Services