Factors to consider before investing in penny stocks

penny stocks

Penny stocks come cheap and can deliver multi-bagger returns, if chosen wisely. But choose the wrong one, and your money can go down the drain. Here’s what you need to look for, to pick the right penny stock.

Penny stocks are favourites with retail investors as these stocks usually trade at less than Rs 10. These stocks usually belong to companies having market capitalisation of less than Rs 100 crore. The reason for the popularity of penny stocks among retail investors is that the investor gets more shares for the same amount. So, for example, an investor may be inclined to buy the shares of company A that trades at Rs 6 instead of shares of company B that trades at Rs 600. This is because, for the same amount, he would be getting 100 times more shares of company A than that of company B.

However, the low price of a stock cannot be the sole criterion and justification for your investment decision. This is not to suggest that you should not invest in penny stocks. But you need to be careful and do your homework while investing in these stocks. This is because as penny stocks are low-priced, these are inherently riskier than high-priced stocks. So, let us look at some of the key factors you should consider before investing in penny stocks.

Price vs valuation: Investors are prone to confuse price with value. The value of a stock is determined in relation to its earnings, whereas, the market price is determined by many internal and external factors. So, a low-priced stock may be available at high valuation, while a high-priced stock may be available at low valuation.

In the above example, company A’s stock trades at Rs. 6 and company B’s stock is available at Rs. 600. Now, if the Earning Per Share (EPS) of company A is Re. 0.03 and EPS of company B is Rs. 60, which one is cheaper? Obviously company B, because its Price-Earning (PE) ratio is much lower at 10 (600/60=10), while PE ratio of company A works out at 200 (6/0.03=200)! Hence, company A’s valuation works out 20 times higher than company B’s. So, look for valuation of the stock and not the price. If the valuation justifies the price, you can buy it.

Liquidity in the stock: Penny stocks are usually characterised by low liquidity. This may lead to large bid-ask spread and result in high impact cost to the buyer. Worse, you may not be able to exit or may be forced to exit at a loss due to low liquidity. So, check the daily traded volumes in the stock. If the volumes are too low, avoid the stock. An average daily traded volume of 5-10 lakh shares may be considered as good liquidity for a penny stock. Of course, the volumes should be regular and consistent, and not intermittent or fluctuating wildly every other day.

Price manipulation: Penny stocks are low-priced, so it is easier for the market operators to manipulate their prices. A cartel of market operators can easily jack up the price of a Rs. 2 stock to Rs. 3 and then dump the shares at the higher price. Thereby, the manipulators can get 50% return and make a killing within a few days. Such jacking up of the price results in the stock hitting the upper circuit every day. The unsuspecting investors who buy at Rs. 3 are left in the lurch because the price crashes when manipulators unload their holdings. If the price is being hammered down, the stock will hit lower circuit daily. So, if you buy a stock and the stock hits lower circuit, you cannot sell it as there are no buyers in the stock market! On the other hand, if it hits the upper circuit, you cannot buy it as there are no sellers! Either way, you stand to lose! So, avoid buying stocks that are subject to price manipulation.

Corporate governance: The standard of corporate governance can make or break a company. Poor level of corporate governance can take the company down the dumps even if it is engaged in a promising business. On the other hand, high level of corporate governance instills confidence among stakeholders of the company. For this, the company management should have an unwavering commitment to honesty, transparency and integrity and enforce it down the line. The company needs to make regularly requisite statutory filings and disclosures to the authorities and concerned stakeholders. If the company fails on this count, stay away from it.

Quality of management: Check out if the company has professional management at the top. In a family-run business, the management bandwidth will be low. Lack of professionalism at the decision-making level can impair the efficiency and capabilities of the company and become an impediment to growth. Hence, look at the professional credentials of the management team and invest only if the management quality and bandwidth is high.

Company fundamentals: The stock of a company with weak fundamentals usually sells at a low price. If the company is facing headwinds in its business and making losses on both quarterly and yearly basis, the stock is bound to take a beating. Such stock sells at a low premium in the market or may even sell at a discount to its face value. Hence, before investing in a penny stock, check out the financials of the company. Investing in a loss-making company is like boarding a sinking ship!

Promoters’ and institutional holdings: Check the levels of promoter and institutional holdings in the company. High levels of promoter and institutional stakes indicate their confidence in the business. So, you too can confidently buy the stock. Also, if promoters have not pledged their shares or the quantity pledged is negligible, you may invest in the stock. A company with low promoters’ stake, high level of promoters’ pledged shares and nil or negligible institutional holding is best avoided.

Now that you know what to look for in a penny stock, do your homework diligently before you take a call on whether to invest or avoid.

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