Should you Invest in Penny Stocks?

If you have recently received a salivating SMS recommendation to buy a software stock at Rs.3 with the assurance that it will go up to Rs.20 in 1 month, you are not alone. There are thousands of investors across India getting such investment ideas. Such stocks are popularly referred to as penny stocks. The term penny stock was first coined in the US for stocks quoting below $1. In the Indian context, there are different interpretations. Some refer to stocks quoting below Rs.20 as penny stocks while other refer to stocks quoting below the par value as penny stocks. Should you invest in such penny stocks?

Penny stocks come from various sources. They could be IPO stocks that lost value due to flawed business models. Penny stocks are rarely Nifty or Sensex stocks but they are from the small cap space largely. But even sound stocks of the past often become penny stocks when they begin to default on debt payments.

What should be your investment strategy? Here is what you must remember.

Most penny stocks are quoting low because that is what they are worth

You must not be attracted by the low price because it obviously hides larger fundamental problems with the company behind the stock. Many of the penny stocks were issued as an IPO during the sectoral boom. You will find scores of such infrastructure and realty stocks in the list. Above all, don’t fall for the low P/E ratio trap because the P/E is low for a reason.

You could get trapped in penny stocks due to circular trading

If you ever bought penny stocks, you may often find that the volumes have suddenly vanished or that the spreads have suddenly become too wide. This is a normal practice wherein a clutch of operators enter into agreement with the promoters to jack up the price of the stock by creating artificial demand. Once the goal is achieved, the support is withdrawn and such penny stocks fall vertically.

Penny stocks often end up being just shell companies

Shell companies are businesses that are set up just to move funds through a corporate route. This is something the MCA has been probing quite aggressively along with the ED and the SFIO. The company behind many of these penny stocks tend to show large orders, pay for these large orders and finally the entire set up vanishes. That leaves the company with a negative net worth and shareholders are left holding worthless shares. Since these are small companies, there is hardly any analyst tracking in these companies and that adds to the opacity of these penny stocks.

SEBI has often taken a tough view on penny stock movements

It has been observed in the past that SEBI has been quite wary of such penny stocks due to their potential to create volatility and disrupt the normal functioning of the markets. In the past, it has been seen that when penny stocks became worthless, many small investors were caught off-guard and ended up with huge losses. This led to defaults by these clients on other positions and triggered a crisis for brokers and for the markets as a whole. In late 2005, SEBI had launched a major investigation into penny stocks leading to a vertical fall in such stocks. In 2018 SEBI had imposed additional special margins (ASM) to reduce the speculation in smaller stocks. Such moves tend to hit penny stocks the hardest.

It is your hard earned money after all

There is a very logical reason for avoiding penny stocks in that you don’t need to take unnecessary chances with your hard earned money. There are better ways to put your hard-earned money to use. Most of the penny stocks are high risk stocks with low probability of returns. Effectively, you may be taking on unnecessarily risk on a story where the returns are never going to be commensurate. Whether you are investing in an IPO or in stocks outside the Sensex, go for stocks that have a sound business model and growth to offer. A strategy of buying quality companies that are well researched is a much better option.

You will always come across these odd cases where your friend made a windfall in penny stocks but they are the exceptions rather than the rule. You can be better off without them!