What are penny stocks and precautions before investing in them

If you have been active in the stock markets you would have surely heard of the term called penny stocks. While there is no classic definition of penny stocks, they generally refer to stocks that typically quote at below par value (Rs.10). Sometimes even stocks quoting below Rs.20 are classified as penny stocks. Penny stocks are typically companies that are small in size or are hugely indebted. Many traders and speculators are quite active in penny stocks as they can yield substantial returns in a short span of time. For example it is very easy for a stock to move from Rs.8 to Rs.12. That is a 50% return and is almost like Reliance moving up from Rs.900 to Rs.1350. Obviously, the latter case is a lot more difficult in practice.

SEBI has normally kept a close watch over penny stocks for two reasons. Firstly, SEBI apprehends that many small and innocent investors may get sucked into buying penny stocks without understanding the risks. Secondly, SEBI is also cautious of the fact that many promoters of penny stock companies use this as opportunity to jack up the prices of the stocks and look for an exit. Here are 8 precautions you need to take before getting into penny stocks

Precautions before investing in penny stocks

  • Firstly, check that the company you are investing in has a credible business model. If you get the feeling that the company is just a front-end shell for moving money in and out of the company then that stock is best avoided. They are speculative at best!
  • Check the historic liquidity of the stock. If the stock has hardly traded in the markets in the past few months and has suddenly seen a spurt in volumes then it is time to be cautious. Obviously, a handful of speculators are cornering the stock with a view to offload the stock at higher prices. By buying stocks of this quality, you will only end up being the greater fool who will give exit to these speculators at higher prices.
  • Thanks to the internet, there is a lot of intelligence about companies available on the internet. People are more than enthusiastic about sharing titbits about a company, especially where they feel something is wrong. Check out the websites and more importantly check the popular discussion forums. You are likely to get a lot of insights about the company.
  • Focus on the quality of the management. Not all penny stocks are bad! Some are genuinely good stocks with sound promoters but may have become penny stocks due to unfavourable conditions. That is where the quality of the management comes in. If the management has too many legal cases pending against them or if the management is gradually diluting its stake in the company then it is best to stay away.
  • Dig up facts from the market. When a company claims lofty plans and a rosy future then there will be some independent source to check it out. Talk to some of the analysts, talk to competitors and talk to retail and wholesale dealers. You are likely to get some useful insights on these stocks through the networks.
  • When you are going to commit money as well hear the story from the horse’s mouth. You can directly pick up the phone and call up the management or you can talk to the company secretary to confirm if some of the facts in the press reports are correct. You can also check with the stock exchanges about the company.
  • Penny stocks always operate in a context. You will normally find that penny stocks normally go up as a group. If the froth is too high and SEBI is already making worried noises about penny stocks then it is best to stay off these penny stocks. Most penny stocks tend to overreact on the downside to any negative regulatory pronouncements.
  • Last, but not the least, never bet your bottom dollar on penny stocks. Even if the penny stock looks satisfactory on all the parameters do not overexpose yourself to these penny stocks. You can perhaps keep aside a small allocation of 10% for penny stocks where you are convinced. Also when you enter a penny stock make it a point to keep booking profits at regular intervals.

Remember, there is nothing wrong with penny stocks and not all penny stocks are bad. But penny stocks are vulnerable to manipulation and hence are always on the radar of the regulator. In your larger interest it is always advisable to tread into penny stocks with utmost caution. When the wind is blowing there is no harm in indulging yourself a little bit. But, in the process, do not let the wind carry you away. That is the key!

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