Here are few guideline which tell you about “Are Penny Stocks worth Investing?”:
Penny stocks belong to companies with alow-market capitalization. The company might be a new player in the industry. It might have tremendous growth potential, but it’s yet to be proved. Penny stocks are of companies’ deficit in cash and other resources.
Investors are always enthusiastic about owning penny stocks. If you are looking forward to investing in them, better have a look at attributes of penny stocks.
1. Low-capital base
A small capital base makes these companies highly vulnerable to internal and external risks. One wrong move by the company’s board may jeopardise its overall prospects. It could result in a substantial decline in stock prices. Conversely, one positive development may shoot up their prices considerably. Similarly, market turbulence may lead to severe volatility in stock prices.
2. Bid-ask spreads
Penny stocks are often attributed with huge bid-ask spreads. It is the difference between the price you paid to purchase the share and the selling price.
Ideally, the prices of stocks rise over time gradually and revert to average in the long run. But as regards penny stocks, this might not happen at all.
Prices of penny stocks may keep declining to unimaginable lows. Sometimes, you may not find the proper price to sell your investments.
3. Low face value
The low face value of penny stocks makes them irresistible. Investors often end up loading their portfolios with penny stocks. They are pretty confident about growth prospects of the company. If you too give in to the temptation without examining the company fundamentals, then you too are in for trouble.
You may perceive penny stocks as highly speculative instruments. Owing to high risk, the chances of windfall returns are also high. At the same time, don’t forget that you could lose your shirts in such stocks.
4. Low trading volumes
Penny stocks are not as an ideal investment as these may seem. These are plagued by many loopholes. Due to low trading volumes, liquidity issues may crop up. You may be unable to find buyers to redeem your investments when you need it the most.
Penny stocks trade outside the major stock exchanges. But you will find a lot many trading on NSE and BSE. But there’s always a risk of these getting de-listed from the stock exchange. If such thing happens, you may be unable to sell your penny stocks.
5. Transparency & public disclosure
While investing in equities, looking into company fundamentals becomes the norm. You need information about ratios like P/E, P/B, RoE, net margins, etc. It helps you in assessing the intrinsic worth of the company. This data is accessible only via public disclosures made by the company.
But in the case of penny stocks transparency becomes a big issue. You might not get full disclosure of critical ratios about some of the companies. Others might publish fudged up information to attract investors.
In short, there’s a lot of scope of manipulation in the case of penny stocks. But you can’t overlook the opportunity to make money in them.
Let’s look into the basic operational mechanism of Penny Stocks.
The “Pump and Dump” Mechanism
The entire game of penny stocks is run via the “Pump and Dump” Mechanism. These stocks are operated by a nexus of promoter and operators. The promoters initially hire investment bankers who have a low repute in the market. These investment bankers, in turn, get into a deal with the operators. Operators make fake accounts which are used to buy and sell shares.
Especially during the bullish period, investors tend to be optimistic about everything. Taking advantage of this, the operators try to create a buzz around the stock. They may approach individual investors by e-mails and phone calls. They artificially push up prices via buying the stock in circular trades.
Small investors notice this frenzy; they jump in. They get lured by the rise in price and volumes. When a considerable number of investors have been trapped, the operators start offloading the equity shares.
Offloading in bulk causes the share price to tank. A point reaches when these shares become junk and worthless. The profit made by selling shares at inflated prices is then shared between the promoter and operator.
Also read: 6 factors that affect stock prices in India
Strategies for trading in Penny Stocks
It’s better to avoid trading penny stocks. But if you can’t resist the temptation, then you need to tread carefully. Follow these simple rules to protect yourself from a disaster:
1. Always go for penny stocks that are listed on the stock exchange. Buying stocks, Over-the-counter can be dangerous.
2. Get your hands on technical analysis. Learn the skill of reading charts to understand the pattern of stock price movements.
3. Remember to conduct an in-depth background check before settling for one. It includes analysing company basics like P/E, P/B, net margins, RoE, etc.
4. Don’t fall prey to spurious e-mails promising you millions of rupees in gains. Think before you act.
5. You need to set a threshold limit for asset allocation to penny stocks. Never invest more than 5% of your stock portfolio in these stocks.
6. Looking at the volume of trading is a pre-requisite before diving into the pool of penny stocks. It’s not good to get stuck in any investment. For that, buy penny stocks which are traded in huge volumes.
7. Don’t become an investor who knows the price of everything but the value of nothing. Instead of getting lured by low stock prices, examine the intrinsic worth of the stock.
8. Always keep profit-making penny stocks in your portfolio. Don’t pin false hopes to loss-making stocks. Stocks prices of entities which cease to generate cash flows never recover.
Penny stocks are high risk-high return bet. It’s nothing more than a gamble. You are investing in companies with the suspicious background. That too; with a hope to earn a profit. If it works, you might become rich overnight. If it doesn’t, you may return empty pockets. I would suggest better you go for stocks with strong credentials.