By Nitin Shahi
As the name implies, penny stocks are shares of companies that trade at prices less than Rs 10. Such stocks are highly volatile in nature, and usually carry a lot of risks, mostly due to inadequate liquidity, lack of proper information about the business and smaller numbers of shareholders.
Penny stocks are fickle in nature, have smaller market capitalisations and are prone to manipulation. So if there is a price rise in such stocks, it may so happen that an investor will not be able to sell his shares until the price drops again.
What makes penny stocks so cheap?
One reason might be the fact that the company is new in the industry and does not have a long track record that can lure investors. The other logical reason is that the stock no longer holds value, which could be the result of a variety of reasons such as losses in the business, poor performance, corporate governance issues, etc.
Often the stock of a major business may drop sharply and become dirt cheap because of temporary distress, and smart investors often pick those kinds of businesses to bet on, hoping for a turnaround or buyout.
That might pay off as well, but the risk is, adopting a ‘buy and hold’ approach in such cases can also leave an investor holding such stocks for long if the business goes into stagnation.
What are the risks involved?
Risks and rewards go hand in hand in investing. Good penny stocks might deliver if you are ready to take the chance. Good revival stories do end up making their stocks multibaggers.
Investing in penny stocks should at best be treated as buying a lottery ticket, and too much expectations might result in a huge loss. The capital invested in such stocks should never be more than 2-3 per cent of a portfolio.
Some penny stocks belong to companies that are dangling on the edge of insolvency or carry the possibility of shutdown. In such cases, your investment, big or small, might never come back.
So, are penny stocks worth the risk? Frankly, no.
But if you find a good business, which may be going through a temporary distress or disruption and can develop conviction about the prospects of a bounceback, it may be worth the risk to take an exposure. Remember, such revival stories invariably deliver multibagger returns.
Penny stocks are more advisable for investors who live by trading or those who understand market fundamentals. They are the people who can perceive management behaviour, financials and industry situations better.
But such stocks are a complete no-no for retail investors who fancy them merely because of the small price tag. Remember, Mr Market is smarter than you. It is very unlikely that you have been able to spot a goldmine that the entire universe of market participants has missed out.
(Nitin Shahi is Executive Director of Findoc Financial Services Group. Views are his own)