Should you buy penny stocks?

Low-priced shares are attracting small investors. Find out if you should invest in them
Penny stocks, arguably the riskiest segment of the capital markets, has witnessed a surge of investor interest in the past 12 months. On certain days, the volume of shares traded was almost double the average. It’s mostly small investors who go shopping in this junkyard, trying to find unpolished gems and undiscovered nuggets. For them, these low-priced shares are both an opportunity and a threat. Find the right stock and you can make big money. At the same time, investors in several scrips have lost money . When the markets tanked on July 28, 19 penny stocks hit their 52-week low.

Price versus value

For investors in penny stocks, the low price is a big draw. Instead of buying 10 shares of a bluechip company , they can buy 10,000 shares with the same money. That’s where they make the mistake of confusing price with value.Investors should not read too much into the 52-week high and low levels. Just because a share has touched its 52-week low does not mean it cannot fall further.Big names like Jaiprakash Associates, Unitech, Gujarat NRE Coke, Lanco Infratech and GTL Infrastructure are trading more than 90% below their 5-year lows. “These stocks were doing well as investors disregarded issues dogging these companies. When the companies could not address those issues, the stocks fell,“ says Mayuresh Joshi, Fund Manager, Angel Broking.

Penny stocks can move up if the companies turn around. However, it is difficult to find turnaround cases in the penny stock junkyard. “The turnaround should be sustainable. One quarter of good performance is not enough.Invest only if the company shows an improvement in its performance for at least 4-5 quarters,“ says Joshi.

Rumours versus reality

Buzz of a takeover can inject adrenaline into a stock price. 3iInfotech crashed to a low of `2.18 in May but rumours of a takeover saw the stock hitting the 5% circuit for several days.But basing investments on rumours is dangerous. 3iInfotech shares hit `6.80 in June before going into a tailspin. The share is now trading at `3.80, 44% down from its June high. For investors, there is no other source of information other than the rumours. Brokerages do not track these stocks and analysts don’t waste time on them.

The other problem is that the managements of these companies are not really known for their corporate governance. So, their pronouncements about the prospects of the company should be taken with more than a pinch of salt.

Share price manipulation

The disturbing thing about penny stocks is that their share price is easy to manipulate. The market capitalisation of the 10 smallest companies adds up to `5.51 crore. A cartel of traders with a `2-3 crore budget can easily stage manage a rally in such stocks. They start buying and selling the stock among themselves to give the impression that there is demand for the share.Brokers and operators masquerading as advisers call up unsuspecting investors, nudging them to invest in these low-priced shares that can yield fantastic returns. When investors have taken the bait and are ready to invest, the cartel dump their shares at high prices.

This pump and dump strategy is also used to launder unaccounted money. Last month, Sebi cracked down on suspected tax evasion through stock market investments. “We found that stocks of some companies have gone up by 10-20 times and even more. We probed that if the share price had risen 10 times, had their businesses also grown. Were the profits, turnover, order book, etc, also grown? There was no correlation in the price and the business of these companies,“ Sebi chairman U.K. Sinha said last week. Sebi has banned more than 900 entities and the tax avoidance is estimated at `5,0006,000 crore.

High volatility, low liquidity

stock-tradingThe low prices of penny stocks mean they are very volatile. Even a 5 paise movement in a stock priced at 50 paise constitutes a 10% change. To check the volatility, exchanges have placed curbs on how much a stock can rise in a day .Most penny stocks have a 5 or 10% circuit breaker, meaning the stock can’t rise or fall beyond that level in a day .

While this acts as a cushion for the stock price, it also curbs the liquidity of the stock. When a stock is locked in a lower circuit, it is virtually impossible to sell. Transactions happen on a first come first served basis. You might want to sell 10,000 shares but if there are five lakh shares already in queue, there is a slim chance your shares will get sold that day. The next day, the story might get repeated if you are unable to place your shares in the selling list before other sellers queue up.

The bigger problem is that many of the penny stocks are not traded at all.Of the 2,950 stocks priced below `10, more than half have not been traded in the past 5 years. Almost 60% have not been traded for the past six months.

Should you invest?

Can you make money in penny stocks?
Of course you can, if you buy the right stocks. But you are more likely to lose money . Very few penny stocks are profitable. A better idea would be to invest in a micro-cap equity MF that invests in very small companies. While a penny stock is priced below `10, a micro-cap stock may be priced very high. It’s only that the company has a very low market capitalisation. Micro-cap and small-cap funds dig out such gems.

Source: TOI 17th Aug’2015