The cult classic for finance aficionados, Leonardo DiCaprio fans, or just general movie enthusiasts of the last decade has to be the Hollywood blockbuster ‘Wolf of Wall Street’ with the protagonist Jordan Belfort, a stockbroker, dupes tens of thousands of customers in stock market-related fraud. In particular, Belfort tells his customers to buy penny stocks, i.e. of absolutely useless companies, promising them humongous returns from these shares.
While movies like the Wolf of Wall Street have given penny stocks a very bad image (admittedly one that it deserves), the truth behind these stocks is much more complicated than what popular beliefs are, and we will cover them in this article.
What are penny stocks?
In simple words, penny stocks represent shares of ownership of relatively smaller-sized companies that are publicly listed in a stock exchange. The minimal pricing, the smaller size, and market capitalization of these stocks set them apart from the household names like Infosys, Reliance, Hero Motocorp. As a result, they are also called nano-cap stocks or micro-cap stocks, based on the market capitalization of the company.
It is not necessary that penny stocks in India have to be listed in the National Stock Exchange or Bombay Stock Exchange alone (the two biggest exchanges). These stocks can be listed in any of the smaller stock exchanges like the Calcutta Stock Exchange, Metropolitan Stock Exchange, etc.
If you find a stock that has a market capitalization of fewer than 500 crores, it’s likely a penny stock. You can calculate the market capitalization of the stock by using the formula market capitalization = market price of one share * the total number of shares outstanding.
What are the characteristics of a penny stock?
While this list need not apply to all penny stocks, these are the general features depicted by penny stocks.
- Low-cost: The term ‘penny stocks’ are derived from the American stock markets, where ‘penny’ is the American equivalent to the Indian ‘paisa’. Therefore, it is no surprise that these penny stocks have a much cheaper price per share, typically priced lower than ₹10. This entices investors who can acquire a higher share of ownership with a much smaller investment into that company.
- Lack of Liquidity:- Penny stocks are notorious for their lack of liquidity, i.e. there may not be enough sellers for you to buy the stock and vice versa. This lack of market participants in the stock makes it difficult to close your long/short position and difficult to get the right bid price/ask price. These stocks typically lack this liquidity because companies issuing them tend to be relatively unpopular and not traded often.
- Unpredictable pricing: Adding to the previous point, the difficulty of procuring the most convenient bid price or ask price makes the pricing extremely unpredictable for these stocks. These price variations could result in a lower profit margin or even a loss inclusive of brokerage charges, but could also generate a profit margin many folds of your original investments.
- Much higher returns: Penny stocks can provide enormously higher returns in comparison to stocks of higher market capitalizations, as these shares are typically issued by much smaller companies with an insane potential for growth over the longer term. However, one must note that these stocks also carry the potential to drag your entire investment capital down to zero. Basically, these stocks are very high risk/very high reward games that every investor must play with extreme care.
But why are penny stocks so risky?
The reason why these penny stocks are so risky is the same reason why running a startup is very risky. Such small companies may not have what it takes to survive in high-pressure businesses, or may just crumble due to mismanagement. Growth in these types of stocks tends to be reliant on market conditions, rumors, and announcements for sustained growth in their market capitalization, and hence their share price.
As a result, penny stocks carry risks that most large-cap companies do not, and these include:-
- Lack of information availability: Penny stocks usually tend to lack detailed public information regarding their financial strength, past performances, growth prospects, underlying issues, etc, causing excited investors to put in their money half-wittingly. It is difficult to find relevant information before investing, and one must take extra precautions and do extra research before taking the financial plunge.
- Pump and Dump schemes: Going back to what Jordan Belfort did for a fortune in ‘Wolf of Wall Street’, pump and dump scams in penny stock are the biggest cause for its notorious image internationally. These scams are characterized by the massive purchasing of penny stocks to create artificial demand in these companies (AKA pump), attracting other investors to buy these stocks as well. The scammers then proceed to sell all these shares and create a massive bearish demand (AKA dump), causing the prices to fall drastically, usually back to their original levels with innocent investors losing a lot of money.
How to identify good penny stocks
The due diligence that you are required to conduct before investing in a penny stock is much more advanced than that of a large-cap stock due to the previously mentioned reasons. Because this is much harder, your chances of going wrong are much higher as well. However, this is not an impossible task, and we can take a look at legendary investor Vijay Kedia for inspiration. Kedia was able to invest in companies like Atul Auto, Cera Sanitaryware, and Aegis Logistic back when they were penny stocks, and had continued to appreciate over 100 times over the next 10-12 years.
Vijay Kedia follows the SMILE investing principle very religiously, i.e. Small size, Medium experience, Large aspirations, and Extra-large market potential. He advises finding companies with honest and ambitious management in an industry that is not monopolistic in nature. And the most important part of this advice is to remain invested in the company for the majority of the growth phase, without selling during downturns.
Identifying and profiling such management during the early stages of the company is the hardest part of penny stock investing, but if done right, it is possible to convert a few lakhs thousands into hundreds of crores over a long enough time frame, as Vijay Kedia has done.
There are broadly two extreme reactions you would get from the words ‘penny stock’, with one group trading these stocks based on online pump and dump schemes, while the other being extremely pessimistic. The reality is that it is possible to make a fortune out of carefully investing in penny stocks of companies that you have done your due diligence in. Companies like Apple, Infosys, Reliance Industries, etc. were publicly listed penny stocks too once upon a time, and investors who have done their due diligence and invested in these companies have gone on to become multi-millionaires and even billionaires.