Penny Stocks

Penny stocks in India are mostly the ones which trades in single digits on stock exchanges. A broader definition can be that if a price of a stock is below INR 10, then it’s a penny stock.

These stocks have got their names from the price at which they trade. As they trade at like INR 2, 3, etc. per share, hence the name.

Few of the key characteristics of such stocks are:

• Low volume – Many investors are not interested in these stocks and hence there are very low volumes in trade in these on exchanges.
• Low interest – These companies because of their wealth erosion history and virtually no earnings growth, don’t garner any significant attention from investors or traders.
• Very low market cap – These are very small companies with low valuations and low net worth. (Market cap is the total value of a company and is calculated by multiplying total number of shares and price per share of a company. Number of shares of a company should not be confused with free float. Free float is the number of shares of a company which is there in the secondary market to trade and are always a subset of total shares).
• Very volatile – These shares have a low float in the market and these are characterized by low price. Hence it’s easy to manipulate their share price. This makes them very volatile on both sides, rise and decline.
• Poor performance track record – They have become penny for a reason and the main reason is poor performance in earnings growth over a period of time.
• Low liquidity – Liquidity refers to the characteristic of a stock as to how quickly you can buy or sell a huge quantity without adversely affecting the stock price. In the case of penny stocks, a significant volume on any side can affect the share price adversely.
• Wide spread – Spread refers to the gap in a sell and buy price. For example, an investor wants to a buy a stock at 6 and another one wants to sell it at 9. This gap of 3 Re is the spread for this particular stock and it is usually very high for penny stocks.Thus, the transactions dont reflect the market price and usually happens at a discount or premium.

• Reasons for them to be penny – There are reasons for these stocks to be penny in terms of poor management, no earnings growth, consistent under performance, etc. Hence, an investor should not be lured into them without a proper research
• Bull market play – In a bull market in a country, there is a major economic recovery and growth. Amidst such an economic boom, every sector and company does well as the organic growth creates huge demand for virtually everything. Hence, earnings of poorly managed companies can also post a decent growth. However, these earnings fade away when the economic environment recedes and declines. Thus, the high seen in such stocks may never come back. This results in huge wealth erosion and can even make an investor permanently exit the stock markets.

Hence, we should be extremely wary before taking an investment and a trading bet on penny stocks. Most of the bullish calls in them will come out saying that the investment amount can grow in multiples and that the stock has bottomed out.

But as per me, investment is protection of capital first and then returns. And there is no point in making an investment in an instrument where in there is a serious threat to the invested capital.

Also, when these stocks start falling, there are no buyers and hence any investment done in them gets stuck and there is virtually no exit. And by the time, an exit opportunity comes, these stocks have lost so much of value that there isn’t anything left for the person holding them.

Hence, again as a point of reiteration, penny stocks are a big no-no from our side.