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 which are in the range of INR 0.05 to INR 10 per share. And for investors, these low prices are a big attraction as it allows them to buy shares of these companies in huge quantities. So, instead of buying 2 shares of Eicher Motors for about INR 38,400 (INR 19,200 per share) or any other fundamentally sound company, investors think it’s better to buy a truckload of 19,000 shares of some penny stock that trades at approx. INR 2. The upside potential also seems unlimited for these stocks, as investors believe that even a small spike in the price can help them amass huge profits.
However, does it work? And is it possible for the stock to climb to INR 10 from INR 2 in the blink of an eye?
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 sometimes. However, it is extremely difficult to find such turnaround cases and chances of being right are very low.
Why penny stocks are considered perilous investments?
- 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.
- 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 difficult to sell the stock.
- 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 a 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 INR 100+ to just INR 0.33 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 a long term is the key to wealth creation.
The four most expensive words in the English language are, “This time it’s different.”
– Sir John Templeton