Penny stocks attract investors for many reasons. Most notably, you don’t need a huge bankroll to get started, and you can trade with confidence knowing that you don’t need to put as much money on the line compared with other account types to start trading.
But penny stocks are a bit notorious for the difficulty in terms of making a profit. Investors also often fall into value traps while selecting penny stocks as they trade at a lower price.
However, many penny stocks that had strong fundamentals also went on to become multi baggers over time. So how does one go about selecting the best penny stocks for their portfolio? Here’s an article that will help you with the approach. Read on!
What are Penny Stocks?
For the unversed, penny stocks are stocks that trade at a very low price. Think about stocks that sell at below Rs.10.They belong to companies that have a very low market capitalization and hence have limited information about them.
Also, penny stocks usually lack liquidity. Since the trading volumes are low, these stocks have a large bid-ask spread and carry a high amount of risk. People invest in penny stocks for various reasons. Since the price of these stocks is low, they don’t need to risk a lot of money to invest in them as compared to other stocks. Also, these stocks have the potential to offer higher returns than other stocks since the companies have an exponential potential to grow.
Now that we know what penny stocks are, let’s see how to pick winning penny stocks in India
1. Decide if Penny Stocks are Right for You
The first thing that you need to think about is if you are comfortable with the high levels of risks associated with these stocks. If you find them to be too risky, then regardless of the returns they promise, it would be prudent to walk away.
2. Understand the Markets
Investing in penny stocks requires a good understanding of the stock markets. There are various factors that drive stock prices like a war, election, natural disaster, change in government policies, the introduction of new technology, etc. Since these are not fundamentally strong companies, they react strongly to even minor events. Hence, investors with a sound understanding of the stock markets are usually better at picking penny stocks than novices.
Also, since the price is low, many companies or even individuals might manipulate the demand for such stocks by buying them in bulk. Once the price jumps due to an increase in demand, they sell in bulk too causing the prices to nosedive. Therefore, ensure that you understand the markets thoroughly before looking in this direction
In the stock market, a majority chunk of stocks is small-caps and lower. Hence, when you start looking for penny stocks, you will have hundreds of options. Most people investing in large-cap or mid-cap stocks are used to creating a shortlist of companies that they want to invest in and then analyzing the company’s fundamentals to arrive at the final list of stocks that fit into their investment plan. With penny stocks, this strategy would need to be tweaked a bit.
First, you need to create a broad set of criteria that can help you identify the industry, sector, etc. to create a primary list of stocks that you want to consider. Then, you keep fine-tuning the criteria to arrive at the final list.
For example, you can start looking at the ITES sector since your research says that there are many exciting startups and small companies in the sector that have a bright future.
You will then start weeding out names and try to find the few who have the best chance to turn into multi-baggers. With time and experience, you will be able to create filters based on macroeconomic events too.
4. Do Some Paper Trading (Practice)
Paper trading is creating a hypothetical portfolio of stocks (without real money) and trading them as if you would in the market. This allows you to assess your level of preparedness to enter the markets and make the right investment decisions. So, you can start an excel sheet that lists penny stocks that you would buy today if you were to start trading. Also, create a list of penny stocks to watch. Write down the name of the scrip, volume, and market price. Track it and when you decide to sell, make a sale entry on the sheet. Do it for some time and assess how your imaginary portfolio performs. This can help you fine-tune your process and choose the right stocks. Do this for two-three months to get a clearer picture.
5. Understand Share price and Valuation
One term that is wrongly associated with penny stocks is ‘affordable’. When you are buying something, getting more shares for the same amount seems like a better deal. Let’s say that you want to invest Rs.5000 in shares and are considering two options:
- Company A – selling at Rs.2 per share; and
- Company B – selling at Rs.10 per share
If you only look at the stock price, then you will be able to buy 2500 shares of Company A and 500 shares of Company B. Which of the two seems to offer a higher value for your money? At first glance, it is Company A, right? Most new investors rationalize this thought by thinking that since the price is so low, there is a huge opportunity for growth. And, if the stock turns multibagger, then having more shares can multiply their profits. This can be a counterproductive approach.
Before you invest in any stock (penny or not), it is important to assess the value of the stock based on the company’s performance. There are many ways to find this value:
- Book value per share – calculated by dividing the net worth of the company by the total number of outstanding shares. This gives you an idea of the intrinsic value of the share, based on the company’s performance over time.
- P/E ratio – calculated by dividing the stock price by the company’s earnings per share. This can help you understand if the company is overvalued or undervalued. This is important for penny stocks since there can be times when a stock price of Rs.2 will be overvalued if the company is not doing well and probably heading towards closure.
You can also look at the dividend discount model, CCI pricing model, and analyze the company’s free cash flow to assess the intrinsic value of the share.
Remember, the market price of a stock is an indicator of its demand and supply which can change due to several external conditions. Hence, while investing, it is important to consider factors internal to the company and assess its value.
6. Beware of Constant Dilution
A company offers shares to raise capital. Usually, investors expect companies to use this capital for expansion and/or growth. However, smaller companies might need to raise more capital or issue employee stock options to attract good talent. This can lead to a dilution in the ownership percentage of existing investors.
Let’s say that a company has issued one lakh shares to one lakh shareholders. Hence, each shareholder has a 1% share in the company. Now, let’s assume that the company wants to raise more capital and issues one lakh new shares to one lakh new shareholders. This will bring down each shareholder’s share in the company to 0.5% and also cause the share price to drop (more supply).
Hence, if a company is constantly issuing new shares, then the value of shares held by the existing shareholders will drop. Avoid companies that have a history of constantly changing its share structure.
7. Avoid Speculation
Do all penny stocks have low market capitalizations? Not necessarily. Also, while market capitalization might give you an idea of the market worth of the company, it by no means is an indicator of how the company might perform.
Therefore, it is important to assess the fundamentals of the company before investing. Look at factors like the business structure of the company and assess if it can turn a profit based on its operations. Also, look at the competition, efficiency of the management team, free cash flow management, financial records, and other fundamental factors to understand if the company can do something to change the investor perception and experience an increase in demand for its stocks.
Sometimes, external factors like the current pandemic can push stock prices down to below Rs.10. This can include stocks of good companies that are specifically impacted by the situation. These are the hidden gems that you can find if are willing to do your homework and identify possible winners.
Remember, stock prices can be low for a variety of reasons. Hence, don’t invest in a stock if you don’t know why it is trading at low prices and are confident that the company will turn things around based on facts and figures of the company. You might feel inclined to speculate – avoid it!
8. Beware of the Gold Rush Approach
Many new investors are attracted to penny stocks since they are cheap and expect to turn their investment of a few thousand rupees into lakhs. The internet is full of rags-to-riches stories that usually talk about penny stocks turning multi-baggers. While this is not completely impossible – it is very rare.
In the penny stock segment, there is a tendency of investors that I like to call the Gold Rush approach. Once people hear about a certain penny stock offering 5X or 10X returns, they tend to gravitate towards it resulting in a buying spree and a subsequent rise in the stock price.
Most investors don’t realize that if the company is not fundamentally strong, then this rally can nosedive overnight! Right from the Tulip mania in the 1600s to the Dot Com Bubble in the twenty-first century, the gold-rush approach has caused huge losses to people for investing without analyzing.
A simple search online for how to find penny stocks in India can lead you to many such gold-rush stocks that novice investors are buying hoping for a jackpot. Hence, ensure that you research thoroughly and bet on the company NOT the stock price.
9. Know Your Investment Horizon
Penny stocks are not recommended for intraday trades or short-term positions. Remember, stock prices are governed by the demand and supply in the market that stems from the general perception of the company. Even if the company does well, changing investor perception takes time. Therefore, look at a medium-to-long-term investment horizon.
10. Monitor Your Investments Regularly
Penny stocks can be a great way to understand how the markets respond to a company’s performance or macroeconomic factors that impact the company. Hence, once you have invested in a portfolio of penny stocks, monitor them regularly. This will allow you to understand trading patterns and make better investments in the future.
While returns can seem promising, it is important to remember that penny stocks carry high risks. Hence, ensure that you conduct thorough research before investing.
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