Home » What are penny stocks and should you invest in them?

What are penny stocks and should you invest in them?

What are penny stocks and should you invest in them?

Photo courtesy Rodney Productions on Pexels.

Penny stocks trade at very low prices on the stock exchange. These are the shares of very small publicly traded companies whose prices can range a little above zero and go to 10, 20, or 30 rupees or slightly more. The stocks are favorite among new investors who don’t have much money and hence can buy large quantities even with small amounts of money. Since they are low in price they provide a significant upside to retail investors. When chosen wisely they can generate multi-bagger returns. The penny stocks are mainly of growing companies that often have limited resources.

The main features of penny stocks are-

1) Lack of information-

When investing in the stock market gathering all the information about a stock is of utmost importance; be it the financials or other details. But in the penny stocks there is often a lack of information on the history and corporate governance of the company. The information that is available may not be from reliable sources and this can put the investors’ money at a risk.

2) Low Liquidity-

There is a lack of information on penny stocks and they are mostly not well-researched; the result is that most experienced investors avoid them. Penny stocks often trade infrequently and there is a lack of buyers in the market. Due to this, the investors may find it difficult to sell. If in any case, a person decides to invest in a penny stock they should look at the trading volumes so that they may be able to support the size of their trade and get a comfortable exit.

3) High Volatility-

Penny stocks have high volatility as they are preferred by people who wish to make quick money. Since they are quite cheap they are bought and sold in huge quantities by many of the big traders resulting in high volatility. Due to the high volatility, there is a higher potential for gains or losses. There are many investors who have lost their entire investment in penny stocks because many of these small companies fail often. Therefore penny stocks are considered highly risky investments.

4) Low Price-

Penny stocks trade at low prices and most of the traders wish to purchase large quantities at low prices and want to exit once they get some returns. These companies are often not transparent and many times don’t comply with the stock exchange requirements. Therefore large investors and mutual funds keep away from them due to a lack of information.

5) People can manipulate these stocks-

Companies with ultra-small market capitalization can easily be manipulated by the promoters and the brokers as they have low floating stock in the market. These people can often put money and move the prices which can’t be done with stocks having large market capitalization.

6) Stocks touching circuit filters-

There are many penny stocks that touch the upper circuit for many days without any news and then once the operator moves out they touch the lower circuits for days on end, giving no chance to the small investors to exit.

7) Transaction cost-

The transaction cost in some of the penny stocks is higher as the brokerage is charged on a per-share basis. At low prices and less volume many times the spread between the bid and ask can turn out to be significant in percentage.

8) Good for beginners to learn-

Penny stocks don’t require much investment amount and if a person is just starting out these stocks offer a great level of freedom to experiment. The stocks are mainly speculative and don’t follow technical analysis. The investment amount is also low so there won’t be very heavy losses.

Things to consider while investing in penny stocks-

  • Study thoroughly the financials of the company and its growth.  Try to find the future plans of the company and the past performance of the management.
  • Is the company profitable or would it soon become profitable? Check the profit history of the company. If the past shows that the company has been regularly making losses the stock should be avoided.
  • Does the company have too much debt? Often companies fail when they have too much debt. When the business cycle is not favorable it makes survival difficult and the business can fail.
  • Invest only if you understand the business model and products.
  • Check the promoter holding in the company and whether their shares are pledged. Companies that have significant owner holding are more investor friendly than those where the owner has a small stake.
  • Check the competitors of the company and whether would it be able to perform against them.
  • Consider a stock if it is trading at a deep discount to its book value and has a huge margin of safety.
  • The stock that you select should have reasonable liquidity.
  • Invest only the money that you can afford to lose. Investing heavily in penny stocks is very risky and you may lose your entire capital if you are not careful. Only a small part of your capital should be invested.
  • Do your own research on the stock rather than depending on the social media channels as many of them may be fed information by the operators and you may lose your hard-earned money.
  • Investing in penny stocks is not for the long term. Once you see a sharp increase in price exit from these stocks or at least sell a part quantity of your portfolio.
  • Be ready to book losses when the investment goes wrong. If you try to average a penny stock you may be digging a bigger hole.

How much should you invest in penny stocks?

Though penny stocks, when they rise can provide a very high return, a person should not invest more than 7-10% of their portfolio in them.

Blue chips are companies that are well established with their products and financially stable. They have a great past track record. As against this penny stocks have limited information available, and liquidity problems, many of them have a high probability of fraud and can go bankrupt. The only reason a person invests in them is that they are inexpensive and large quantities can be bought with a small amount of money. A few penny stocks can generate multi-bagger returns, which is that they deliver returns multiple times the amount invested in a short period of time, unlike the blue chips. A person should carry out thorough research in penny stocks and invest only a small part of their portfolio so as not to lose all their money in case the investment goes sour.

Leave a Reply

Your email address will not be published. Required fields are marked *