As per Securities & Exchange Commission (SEC), U.S.A, Penny Stocks are generally stocks issued by small companies which trade at less than $5 per share. In India, the words ‘penny stocks’ are not defined anywhere but are usually associated with stocks which trade for very little value and mostly below Rs 10.

Is it a good idea to invest in penny stocks?

The way I would like to define such an investment should throw some light on the potential benefits of investing in penny stocks – “an investment where even if 9 out of 10 stocks fail, your losses appear tiny with the kind of returns that the one winner makes”.

Mostly, these are the stocks of small companies which are either at a very young stage of their development, or which have not grown much over time for various reasons. People often confuse penny stocks with stocks in companies with poor fundamentals and operator driven scripts. Ideally, the latter should be treated as fraudulent or bad stocks whether they are penny stocks or not.

It is true that most penny stocks may be easy for operators to drive the prices of, mainly because of:

(i) Low liquidity; and

(ii) Low market cap;

It does not however mean that investing in penny stocks is akin to investing in companies with low quality or poor fundamentals.

List of some penny stocks listed on the BSE of India:

Company Industry Price (In Rs.)
Birla Pacific Medspa Limited Healthcare Services 0.48
Globus Corporation Limited Comm. Trading & Distribution 0.36
Flawless Diamond (India) Limited Other Apparels & Accessories 0.25
Alka Securities Limited Finance (including NBFCs) 0.37
ABL Biotechnologies Limited Pharmaceuticals 5.25
Baron Infotech Limited IT Software Products 0.59
Abhishek Corporation Limited Textiles 4.34
GTN Textiles Limited Textiles 9.46
Eastern Sugar & Industries Limited Sugar 4.00
GR Cables Limited Telecom Cables 0.61

These stocks are generally highly speculative and highly risk, trade in low volume and tend to exhibit significant price volatility – i.e., there is likely to be substantial variability in their pricing pattern. As a result, investors should be ready for the possibility that they may lose substantial or their entire investment while investing in penny stocks.

Risks associated with investing in Penny Stocks

  1. Highly Volatile – Such stocks are very volatile to trade in. Since their prices are so low, even a small increase/decrease in price can double or half the value of investment. Moreover, in most cases the total market cap of such companies is very less which makes it even more easy to buy large blocks of shares in them which leads to volatility.
  1. Liquidity – In general terms, penny stocks are not very frequently traded because of which any small order can cause major price fluctuation. In addition, it may be difficult for you to exit due to lack of sufficient buyers in the market.
  1. Insufficient information –Since not many investors / analysts track such companies, there is lack of available information on them. Before investing in these stocks, you will need to try harder than usual to procure information on these companies.
  1. Rumors & manipulation – I can safely say that in 90% + cases, penny stocks are recommended by operators after they purchase a huge quantity in them. As I stated above, it is extremely easy to cause the price of such stocks to move up or down by a few percentage points. A few small orders by a small number of retail investors will be enough to cause a 5-10% movement (or more) in the stock price. This is the biggest risk associated with Investing in penny stocks. Ideally, you must try to ignore immediate actionable tips and if you are planning to invest in penny stocks, do so with some amount of research and most importantly – before the stock starts getting recommended on online forums J. Holding your positions before a hysteria is most likely to go in your favour as you are most likely to acquire your holding even before the operator.

What Makes Investing In Penny Stock So Attractive?

Investing in penny stocks attracts investors for 3 main reasons:

I.            Cost Price – They don’t cost much and you can buy a large number of these shares for very little money. This gives the investors, a sense of holding on to something significant and sizeable. Many small investors, who cannot afford to buy a substantial number of shares in a large company like Colgate, ITC etc, can easily afford to purchase 100 or even 1,000 units of such penny stocks.

II.            Immense Potential – It is true that if you manage to invest in a business at a really young stage, you are likely to be very rich if that business does well. Investing in penny stocks could result in your acquiring a large percentage of shareholding in the company at a time when not many investors are holding its shares.

III.            Small Movement Gains – Even a small increase in a price can translate into a sizable profit. For example, a single rupee movement for a stock trading at Rs. 2 (which appreciates by Rs. 1 to Rs. 3) translates into a 50 % return on investment. On the other side, if a Rs. 125 or Rs. 150 stock increases by Rs. 1, the increase in your total investment would be just 0.80% and 0.67%, respectively.

Given the risks associated with penny stocks, can you cash in on the potential growth of these stocks? There are some basic rules that you need to follow while picking a penny stock to give yourself the best chance of making good returns from your investments.

Rules To Remember when Investing In Penny Stocks

  1. Don’t invest in just 1 or 2 penny stocks – When it comes to investing in penny stocks, remember this basic rule – “no matter how correct you may be, in all likelihood a majority of these companies will disappear and your wealth could be destroyed by 100%”. Diversification is far more important here than it is when you invest in any other type of stocks or asset classCreate a portfolio of at least 12 to 18 penny stocks if not more.
  1. Watch the trading volume – Pennystocks are normally illiquid. If you are interested in buying a large quantity of penny stocks make sure that the stock is frequently traded. It is important that you study the trading volume very closely, at least for the last 6 months. Focus only on buying shares where you see high volume of trading.
  1. Research the Underlying business, financials – Don’t forget to do your own research about what the company does and into its financials. You should pay the same amount of attention and diligence as you would before investing in any large or mid cap company, if not more. Sometime back I wrote a post on things to look for when before investing in a company where I spoke about some of these points.
  1. Time your trades – If your stocks are performing well and are significantly up from your purchase price then sell your stocks and take your profit unless you are convinced that the appreciation was not a result of any operator driven activity and that the underlying business has indeed improved or has started doing well and that this was likely to continue in future.
  1. Strict stop-loss targets – Stop-loss orders are meant to protect you from shares which fall significantly and quickly. Work with very strict stop-loss targets. Don’t live in the hope that a stock cannot go down from a particular level.
  1. Avoid the Forums – Avoid investing in penny stocks on the basis of what you read or hear on chat forums and free message boards. In almost 100% cases, they serve as the hunting ground of operators whose very job is to generate interest in such stocks after acquiring a large stake in an underlying stock. Often this happens in concert with the management of the company, which acts in concert with such operators in trying to create interest in the stock.

 


Fact – John Templeton started out by buying into 100 stocks in more than a 100 odd companies in 1939, all of which were penny stock investments. From there Sir John Templeton went on to become one of the most celebrated stock investors of all times.