Last year at a friend’s birthday party, the topic of stocks came up and we began discussing various interesting things going on. Vikas, a friend of mine, excitedly told me about a company whose stocks he had purchased. It was a company called Svam software and he purchased 1,00,000 shares at 90 paise each. The total investment was Rs 90,000 and was made on advice from some friend who had made some profit from it.

A few days back when I met Vikas again and asked about his investment, he did not seem excited at all. He said that he had to sell the shares at 38 paise each and that too after waiting for a long time. He made a loss of Rs 52,000 from this investment, or rather gamble. And this is why penny stocks are not for everyone. Want to know more? Keep reading…

What the heck are penny stocks?

Although there is no official definition of penny stocks, we generally consider stocks trading below Rs 10 as penny stocks. In the US, stocks trading below $5 are classified as penny stocks. Another classification of penny stocks is based on their market capitalization, i.e. the Total value of all shares listed on a stock exchange. Penny stocks are generally the stocks of very small and relatively new companies in the market.

The Pros and Cons of Penny Stocks

Penny stocks represent small, relatively new companies. The problem with very small and new companies is that very less information about them is available. It is hard to study these companies and make investment decisions. However, they have both pros and cons. Let us look at them.

Pros of Penny Stocks

• Huge potential for growth if the company is selected properly.
• Low net worth investors can purchase more stock.

Cons of Penny Stocks

• Hard to buy and sell: Penny stocks can be very hard to buy or sell. We use the term liquidity for expressing how fast or slow a stock can be bought/sold. If the stock is easy to buy and sell, i.e. there is a good supply and demand, we say that the stock is highly liquid. The stocks of big popular companies are generally very liquid. Penny stocks, on the other hand, represent small, new and unpopular companies. No doubt very few people are interested in buying or selling them – thus these have very less liquidity. The problem with low liquidity is that you may want to sell your stocks but there might not be any buyers and vice-versa. We can compare their liquidity with real estate which also takes time to buy or sell.
• Subject to Scams: Penny stocks are often subject to scams and frauds. Dishonest promoters of these companies may manipulate prices by tricking unsuspecting investors through free stock picks or newsletters which are biased. A rumor about the company often leads to great change in prices giving an option to the dishonest to book profits by selling. Dishonest promoters may paint a weak company in a positive light to drive up prices. This is called putting lipstick on a pig.
• Represents Low-quality companies: A vast majority of all penny stock companies are rubbish which got listed on a stock exchange just to raise capital. More than 90% of penny stock companies are very low-quality businesses with horrible management personnel. Many of these companies even do not care about a website for their companies. I have come across companies with no website/expired domain names.
• Extremely volatile: Small companies’ stocks are very sensitive to any news about the company. The news may be true or false but it creates a frenzy among investors. Prices may shoot up or crash down in a single day resulting in huge gains/losses. This extreme volatility is not seen in larger companies as reliable information about them is present and they are closely watched by a lot of professionals, therefore, any change in prices is not as sudden.

Some Diamonds once found in the penny stock space

As mentioned in the pros of penny stocks above, if quality businesses are identified, the potential for profits is unimaginable. There have been examples of companies once listed as penny stocks which have performed exceptionally well. Some of them are Ford Motor Company, Nokia, Alcatel Lucent, American Airlines, Ashok Leyland, Dabur India, etc.

The opportunity exists for those who can…

No doubt the penny stock universe is filled with >90% rubbish companies which are bound to make losses. It is difficult to find good quality companies in this space, however opportunities exist for those who can:

• Accept the Risk – You are aware of the risk and accept it in exchange for potentially greater returns.
• Find overblown risk perceptions – There may be unnecessary negativity about a company based on overblown risk factors. For example, if a pharmaceutical company with 10 drugs fail to get government approval for 1 drug, the stock prices may collapse. But investors who acknowledge that 9 drugs are still in development will accumulate the shares of the company at a much less price.
• Identify shrinking degrees of risk – Certain risk factors which keep the prices down for companies may mitigate but the stock price does not reflect them immediately. This presents an opportunity for buying.

What events affect Penny stock prices?

Big companies might encounter issues that they barely even notice, while these events may derail the micro cap companies. For example, consider a situation where the Vice President of Marketing of Bajaj Automobiles resigns. This event will not trigger a panic among investors as Bajaj is a stable business and has come out of several such events smoothly. On the other hand, if this event had occurred with a much smaller automobile manufacturer, there would have been a much drastic impact on the share prices.

Some events which can affect the stock movement are:

1. Employee resignations, Brain drain.
2. Intellectual property events
3. Financial Results
4. Customer changes (Addition/removal of customers)
5. Changes in competition.
6. Lawsuits
7. Regulatory approvals/denials (For example, Emission tests in automobiles, Drug safety approvals, etc.)

What are some risky misconception about penny stocks?

People often develop some misconceptions about penny stocks due to their low price. Some of them which one must avoid are:

• They can’t fall much lower – This is a ridiculous statement with no meaning. Remember – a stock cannot remember anything. It has no memory. So if it has fallen from Rs 2 to Rs 0.50, it can even go to 0. We can compare large-cap companies to heavy stones and penny stock companies to small and light pieces of rocks. It then obviously follows that it is easier to move small light rocks than heavy large stones.
• The downside is smaller than blue-chip (large-cap) stocks – This is another misconception in the minds of new investors. Ask yourself this question: There are two companies – 1. The price per share is Rs 2.5. 2. The price per share is Rs 800. Which price is closer to zero? The first one. It is much easier for Rs 2.5 to go to zero than for Rs 800 to reach that point. If the price of the second company goes from Rs 800 to Rs 650, you lose 18.75%. But if the stock of the first company falls from Rs 2.5 to Re1, you lose 60% of your investment. I hope you got the point.

Are Penny stocks for you?

Ask yourself these questions before putting any money into penny stocks.

Are you willing to do the effort?

Can you commit to studying enough about stocks before buying them? If doubtful, stay away.

Do you have a high tolerance for risk?

Will you be able to sleep at night peacefully if half of your investment is wiped out in a day? No matter how carefully you pick penny stocks, the risk is always there.

What do you intend to do – play, invest, or risk money?

Make your goals clear before investing and do not put any money from necessary expenditures. Also, do not invest any rupee that you need in the short term.

Do you have realistic expectations?

Are you expecting to become a millionaire overnight? I’m sorry to tell you this but this does not happen and the probability is no better than winning a national lottery. So keep your desires realistic and be patient.

Do you have the time for research?

Seriously, if you do not have the time for research, please don’t even think about penny stocks. It is almost sure you will lose some or all of your money. And never ever invest on someone’s advice before researching yourself.

Verdict

Penny stocks are a risky game. Most successful investors advice staying away from penny stocks because the average investor does not possess the skills or the patience to study and find a good company in a sea of bad companies. It is therefore wise to stay away from penny stocks and look for other opportunities in the larger and established companies. Still, if you wish to invest in penny stocks, I’d recommend some books: Penny stocks for Dummies by Peter Leeds and Penny Stocks: The Ultimate Strategy Guide to Trading Penny Stocks by Prof. Tyler Yamazaki. I’d like to end this with this wise quote from Sir Warren Buffett which clearly brings out the importance of quality over price.