Penny stocks have attracted investors for years. And at first glance, the reasons for this attraction are quite obvious.
They seem extremely cheap when you consider the share prices - generally below Rs 5 and at times, even below Rs 1 per share! And for investors, these low prices are a big attraction as it allows them to buy shares in these companies in huge quantities. So instead of buying 2 shares of Eicher Motors for about Rs 60,000 (~ Rs 29,500 per share) or any other fundamentally sound company, investors think it’s better to buy a truckload of 30,000 shares of some penny stock that trades at Rs 2.
The upside potential also seems unlimited for these stocks, as investors believe that even a small addition to the price can bring in huge profits. After all, how difficult it would be for a stock of Rs 1 to move to Rs 10? It’s just about a few rupees and it will become a big multibagger!
Does it work? And is it as simple as this?
This myth of investing in penny stocks and becoming rich overnight has been attracting investors for many years now.
No doubt that if you look at the price of these penny stocks, they seem very cheap. But by just looking at the share price, investors confuse price with value. Shares cannot be tagged as cheap or expensive only on the basis of price. These shares have actual businesses behind them and they should be valued on the basis of their fundamentals - like business potential, growth, financials, management quality, debt on the books, etc.
Penny stocks trade at low prices not because markets are benevolent and you are getting a good deal. But because markets don’t see much value in their businesses or future growth. Many of these businesses are even on the brink of bankruptcy.
When investors buy these penny stocks, they are basically betting on the businesses turning around or more commonly, just speculating by looking at the share price of such penny stocks. But that seldom works. Of course, some of these perceived ‘bad’ businesses will turn around and speculation might work at some times. However, it is extremely difficult to find such turnaround cases and chances of being right are very low.
We Don’t Recommend Penny Stocks. Why?
We do not cover penny stocks in our research and we don’t include them in our recommended portfolio. There are few reasons for that:
- Penny stocks escape rigorous analysis and scrutiny of big companies and are susceptible to several non disclosures, lack of compliance and transparent reporting systems that big companies cannot escape. Also, since there are too many of them to track, it is not easy to find the most promising ones.
- The publically available information about the business and management of these penny stocks is not enough. And very often, what is available is not reliable either. So it’s difficult to see the full and correct picture in order to make a meaningful study of the stock. Many companies are fairly new and don’t have much history. This lack of history is a big hindrance in our ability to analyze the company’s track record and management decisions in various business cycles. So again, there is lack of enough information.
- The biggest problem is liquidity. These stocks don’t have much liquidity. So even if you are able to buy large quantities and see share prices rise to acceptable levels, you might find it very hard to sell everything when you want due to lack of sufficient buying interest. Due to low prices, these stocks are vulnerable to being manipulated and can swing wildly. Historically, many penny stocks have been manipulated by stock operators for their own benefit.
As evident, the risks attached to investing in these small businesses are very high, even though some of them might turn around and do well. We’d not like to generalize across all genuine opportunities available in this space; having said that the purpose of this article is only to enlighten the investors to stick to the simple tenets of “informed investing” after thorough understanding of "risks and return".
The chances of huge profits in penny stocks come with even bigger chances of suffering huge losses. In fact, it can wipe out your investments in a short duration if you are not careful. For example - shares of PMC Fincorp are down from highs of Rs 100+ to just Rs 0.4 today - loss of more than 99.6%.
Hence, penny stocks are something that we avoid when creating a portfolio of long term picks. Our decades of investment experience tells that buying shares of fundamentally sound and well-run companies and holding them for long term is the key to wealth creation. And that is what we focus on when creating our recommended 5x5 portfolio.