Penny stocks refer to those companies which trade in the open market or over-the-counter at low share prices and low market capitalizations. Moneycontrol.com defines penny stocks as those companies where the share price is anywhere between ₹0.5 and ₹10. Let's look into penny stocks to analyze whether you should be willing to buy penny stocks or are you better off investing at established large-cap companies.
Low liquidity of penny stocks
The fact that penny stocks tend to have much lower liquidity and float than a large-cap company indicates it is difficult to get in and out of these trades. Even if you aim to hold these shares for the long term and for some reason the share price falls, it becomes difficult to exit your position
Penny stocks are not established yet
Unlike Nifty stocks and established large-cap companies, penny stocks companies are likelier to fail earlier and faster, taking away all your investment with it. Like most startups and new companies are expected to fail very early on, penny stock companies are not too different as far as the risk of failure is concerned.
Prone to manipulation and insider trading
Due to its lack of liquidity and float, these companies are likelier to shoot up in share price when bought heavily. This makes it easier for operators to artificially increase the value of the stock and then square off their positions once the price has increased and they have made a substantial amount. However, the ones getting trapped in this manipulation are those traders and investors who bought this stock thinking it could be a multi-bagger due to its recent movement.
Limited information regarding the company
For Nifty stocks and large-cap companies, you can always find information regarding it on the web; details of corporate governance, verified balance sheets and income statements, impending lawsuits, consumer satisfaction, controversies regarding employee misbehavior, a rift in the upper management, etc. However, the same cannot be said for penny stocks as very few (if any at all) news organizations would report on these companies. Hence you will have to go out of your way to research these penny stocks before making a long-term investment in them.
But Pvot, at one point, weren't many large-cap companies also penny stocks?
Absolutely! Indeed, most penny stock companies don't grow to be that big, but the ones that do deliver staggering returns. For example, my uncle had made a small investment in Dabur when it was trading at ₹16. Today, it's trading at ₹539. These things do happen but it wasn't dumb luck. He used to buy and use Dabur products much before their IPO, and he researched the company's profits, balance sheets, and corporate governance before making the decision. Luckily, however, Dabur was still a fairly well-known consumer brand.
In his bestseller "Penny Stock for Dummies", Peter Leeds says that about 6 months of research is needed to know whether a penny stock is worth investing in the long run; and that research includes speaking to the owners, employees, clients, and customers of the company. However, if you feel you'd still like to gamble on trading or investing in a penny stock without any due diligence, it's probably a wiser investment to try your luck in a real casino.