Penny stocks have a broad range of definitions. In the US, penny stocks are the ones quoting below $20. In India, stocks quoting below Rs.20 are normally classified as penny stocks. There are some amazing penny stock success stories in India. Eicher, Crompton Greaves, SAIL were all penny stocks before they became multi-baggers. But the key question is how to identify them and trade them?
Penny stocks can be a tricky game…
Back in 2001, at the peak of the 9/11 equity paranoia, I remember a couple of large steel traders aggressively accumulating SAIL at Rs.3/-. Although, I was never a great fan of penny stocks, I was quite intrigued by their sudden interest in SAIL. More so because, as steel traders, they understood steel much better than most others. Not surprisingly, they made a real killing!
The biggest worry in most penny stocks is the management, which typically tries to use the market euphoria as an opportunity to exit their positions. It begins with a dose of managed news flow, some big bang order announcements and a few willing analysts singing paeans of the turnaround story. In case of SAIL, management quality was never the issue. But more often it is!
The big challenge in penny stocks is how to separate the wheat from the chaff. The likelihood of striking a multi-bagger penny stock is extremely low. The difference between a low-priced stock and a cheap stock is very hazy. But the biggest challenge in any penny stock is in identifying, buying and eventually holding on to the stock to exit profitably. That is the key!
3 REASONS YOU NORMALLY LOSE MONEY IN PENNY STOCKS:
Focusing on new-lows rather than new-highs
Buying penny stocks that are touching new lows daily is a bad idea. Remember, when it comes to these stocks, cheap crap is crap anyway. Focus on new highs rather than new lows. You will get a better deal!
Forgetting that penny stocks are like options
When you buy a penny stock, you are buying an option. You buy calls because you do not mind losing the small premium you pay. In case of penny stocks decide how much loss you are willing to take. Don’t lose your shirt!
Giving too much credence to tipsters
That hot penny stock tip is never going to work in your favour. Most people don’t bother to investigate more about the company while buying a penny stock. Tipsters are always looking for some sucker to exit. Don’t be that!
“If a business does well, then the stock eventually follows” – Warren Buffet
6 STEPS TO PENNY STOCKS THAT WORK FOR YOU
- First and foremost, be as sceptical as possible. Especially, when the management of a penny stock company starts gloating about the future! A good stock never requires an advertisement, at least not by the management. Don’t be a sucker for this sales pitch. Don’t go overboard!
- In the universe of penny stocks, focus on those with higher volume and leadership position. Low volumes are a classic buyer’s trap. You see a lot of price damage by the time you sell. Leadership within the segment is a major advantage. It helps a company better leverage a positive business climate. Watch for them!
- Don’t be too long or too heavy on penny stocks. I know of investors who fall in love with penny stocks and hold on to eternity. Just because a penny stock has a good story, does not mean you bet your bottom dollar on it. Keep a mental time frame for the penny stock story to play out. Otherwise, forget it!
- This is a rule I have often emphasized. If something is too good to be true, then it is probably not true. If you get into a penny stock and it appreciates 40% in a month, just exit without thinking twice. You may miss a multi-bagger, but you exit profitably. Rather safe than sorry!
- The basic rule of penny stocks is to buy slowly and exit hastily. If you want to allocate Rs.100,000 to a few penny stocks, don’t do it all in one shot. Phase out your buying to reduce costs! But when it comes to selling out, don’t wait for too long. The moment you are getting a good price, just exit!
- Avoid the cardinal blunder of short selling a penny stock. Most penny stocks may not be available in the F&O segment. Hence shorting intraday may be the only option. This is fraught with risks as such penny stocks are prone to violent movements. And leveraged positions can truly damage!
INDIAN CASES ON PENNY STOCKS
In India we have seen penny stocks become multi baggers over a period of time. SAIL, Bongaigon Refineries, Crompton Greaves, KPIT Information Systems are all cases. The difference between a good prospect and a junk penny stock is the quality of management, supported by a good business model and fairly sustainable cash flows. Avoid penny stocks that are deep in debt since such penny stocks are most vulnerable to business shocks.
India also has its fair share of high priced stocks which gradually dissipated into becoming worthless stocks as bad management decisions, too much debt and lack of reliable profit models took its toll. At the peak of the technology boom, stocks like Pentamedia, DSQ Software, Himachal Futuristic and Silverline ended up being mere shell companies. Post 2010, companies like Kingfisher and Deccan Chronicle were classic cases of the perils of over-leverage. Beware!
TAKEAWAYS FROM THE “PENNY STOCK” DEBATE…
Penny stocks are not bad. Remember, Sir John Templeton started building his fortune by investing in penny stocks. It is just that investors focus more on the price than the value of the stock. If you focus on companies with sound business models, low leverage and decent management, it is extremely likely that you may hit pay dirt in penny stocks. Try it!
As Peter Lynch put it succinctly, “At the end of the day, making money in stocks is never about brainpower. Most people who have been through high school have the required brains. It is the stomach that counts”. This is especially true of penny stocks where the urge to take decisions in panic or delusion is the highest. Penny stocks are not so bad, after all!