Should you shy away from penny stocks?

At the far end of the stock market spectrum lie extremely low-priced stocks, also called penny stocks. These stocks typically witness active trading in strong bull markets when investors do not shy away from risk. The low price allows investors to purchase a large number of these stocks; the returns are also magnified due to low price.

But these are not for the faint-hearted. Penny stocks are typically illiquid and prone to price manipulation. Timing the entry and exit becomes critical here, making them unsuitable for long-term investors. Only those with an out-sized risk appetite should try their hand at this segment.

In India, penny stocks generally trade between ₹0.05 and ₹10 per share and these stocks are ultra micro-cap companies.

Can deliver multi-fold returns

S DHEEPAK, Chennai-based investor

 

 

Many investors have, however, managed to strike gold investing in these stocks. Chennai-based S Dheepak, an active investor in penny stocks with two decades of experience in stock market trading, says, “I do proper research and have a strategy or checklist while selecting penny stocks. It includes checking the company’s management, history of the stock price, price charts for more than one year and volume build-up or breakouts in the past, whether the company has reasonable debt”.

He also tries to understand what drove the stock price below ₹10, making it a penny stock.

“I had picked Urja Global between ₹1.0 and ₹1.5, which went on to hit ₹10 in a few months. I chose this stock because many other solar sector stocks were also rising, and Urja displayed positive technical analysis cues, which became a high conviction set-up. I restricted my risk with a tight stop-loss. It generated almost 10-fold returns,” says Prashant Tejura, an active day trader and long-term investor.

KUMARAN NITHIYANANDHAN, Businessman

Kumaran Nithiyanandhan, a businessman and a long-term investor, states, “I get some tips from some brokerage research firms and have a group of friends who share the leads and inputs. I don’t just buy because the price is low; I always research and do some background checking before investing. Also, I maintain a strict stop-loss when I buy these penny stocks.”

He has been lucky so far in not losing money while trading in penny stocks. Getting advice from his brokerage, he had made some good profits over the last six months by trading in the stock of Sanwaria Consumers, JP Associates and Unitech.

“Don’t buy unless you are confident about the stock or some events affecting it. In the past, I bought SpiceJet at a very low price as I thought it was too big an airline to fail and it was backed by Sun TV Group. Sanwaria Consumers and SpiceJet have given more than 100 per cent returns”, explains Nithiyanandhan.

Relying on charts

 

PRASHANT TEJURA, Day trader and long-term investor

 

 

However, many rely purely on technical analysis while trading penny stocks.

“Penny stock companies usually have low quality management or negative future outlook. Therefore, speculating on improving fundamentals can be of limited use. Hence, I use basic technical analysis to understand the chart of the sector and the basket of stocks that interests me. Typically, I study dozens of charts every week trying to identify support levels that offer good risk-to-reward ratio,” says Prashant Tejura.

He further adds, “My job as a trader is not to avoid risk but to control it. My holy grail is to manage the risk as per my trading plan and let the profit run to take care of itself.”

Dheepak concedes that he has made losses investing in penny stocks. To mitigate loss, he follows this strategy: “I start cutting my position once it falls below 20 per cent of my cost or if the stop-loss is hit. But if the call is right, I look to take home at least 100 per cent and above. So, risk reward is very much skewed in my favour.”

Key risks

RAVI PADMANABHAN, Full-time investor

 

 

There are multiple risks in investing in penny stocks as they are not fundamentally-sound companies. Ravi Padmanabhan, a full-time investor and founder of Chennai-investors-club, sharing his knowledge and experience, says, “I have seen some of my friends lose money when they bought stocks like Kingfisher, Teledata, KS Oils, GV Films in the last decade. They bought these stocks thinking that these companies will not fall further as they were already trading at only single-digit levels.” Unlike SpiceJet, these stocks failed to turnaround and made huge losses.

Some lessons that Padmanabhan shares are — “never invest in companies that are not making a profit and which have negligible chances for revival. When you make a mistake, it is better to accept it and move on. Refusal to accept a loss can result in complete loss of capital and, in some cases, the stocks are suspended from trading.” Moreover, in some cases, there are risks of de-listing if the company fails to meet the stock market’s disclosure requirements.

Due to low liquidity, penny stocks could be an easy target for price manipulation. Lack of genuine information publicly available on penny stocks is another risk that investors should note. The key to successful investing is to get enough information on the stocks to take informed decisions on whether to buy or sell.