10 Important Facts About Indian Penny Stocks

Penny stocks are investor favourites. The retail crowd especially loves them. They hold the promise of providing huge gains in a short time.

But at the same time, they are without a doubt the riskiest type of stocks. They can crash anytime for any reason. They are infamous for wiping out 90 per cent of investors wealth in a few weeks or months.

Even worse is their low liquidity in most cases. With only a limited number of shares being traded on any given day, a small increase in volume can move the stock in a big way. This is great if the stock moves up but disastrous in case of a decline as most investors won't be able to sell at a decent price.

Despite the risks, penny stocks are almost always popular. The only exception is during bear markets.

So in this article, we will summarise 10 important facts about Indian penny stocks.

What Is A Penny Stock?

Penny stocks are shares of listed companies with low market capitalisation. These stocks usually have low share prices, typically less than Rs 100 and often less than Rs 50.

In the US market, these stocks trade for less than a dollar i.e. for pennies. Hence the name.

These stocks, in general, have poor liquidity in the market i.e. their trading volumes are low. It's common to see penny stocks trade less than a thousand shares a day.

Potential Gains In Penny Stocks

Well-chosen fundamentally strong penny stocks have the potential to deliver profits greater than 1,000 per cent within 1-3 years. This is almost impossible in the case of any other stock category.

This is the main reason for their popularity. Investors are aware of these potential gains and are constantly on the lookout for fundamentally strong penny stocks.

Risks In Penny Stocks

It's common to see penny stocks plunge 80-90 per cent when the market enters a downtrend. This is why investors should be extremely alert and cautious with penny stocks.

Often many retail investors think they can make a fortune in penny stocks. They invest most of their funds into one or just a few penny stocks.

The result is usually a disaster. There is no shortage of stories in the stock market of people losing their life savings in penny stocks.

The Big Penny Stock Myth

There is a big myth about penny stocks in the market. You may have heard it: Penny stocks are the best way to get rich.

Even those who don't invest in the stock market may have heard this myth. In a bull market, more than a few penny stocks will do well. Some will, most certainly become multibagger penny stocks.

This convinces retail investors than penny stock investing is their best bet to get rich in the stock market. What they don't realise is that investing in penny stocks is perhaps the best way to destroy their portfolios.

Their fundamentals are dubious. Their management quality is doubtful. These stocks are very vulnerable to the actions of stock market operators.

Only a few of them are even worth considering as long term investments. Most investors won't find these needles in the haystack.

And that brings us to…

Most Penny Stocks Are Toxic

Penny stocks are plagued with many issues – losses, sluggish revenue growth, high debt, low promoter holding, high promoter pledging – and are not considered prudent investments.

If you invest in toxic penny stocks you're risking the safety of your hard-earned money.

Just think about it. Would you invest in a large-cap stock if the company had a history of making losses?

I'm sure you wouldn't.

So you shouldn't invest in bad penny stocks either. Just because these stocks can go up a lot is not a good enough reason. The risk-reward equation is not in your favour.

If these stocks crash, your capital would be at risk. Even worse, many penny stocks, unlike bluechips, don't recover after the crash.

Only The Top 1 Per Cent Of Penny Stocks Are Worth Your Money

The only penny stocks worth your time and money are the best 1%. They are the only ones that will likely not crash 80-90% and also most likely to rise 10x or more.

Here's how to filter penny stocks…

• First, avoid all penny stocks that have high debt. By high debt, we mean the debt to equity ratio should be less than 1. Ideally, the ratio should be less than 0.5.

• Second, the company's owner should have significant stake. Reject all penny stocks in which the promoter has less than 30 per cent stake. Also, pledging of shares should be a strict NO.

• Third, look for long-term business viability. Penny stocks can deliver great returns like 50x and 100x in the long term. For that to happen its business model should be viable. Look for companies that are likely to be around at least a few years from now.

• Fourth, the company must be generating an income. By income generating, it must be profitable today. If the promised profits are in the future and the companies are making losses today, stay away.

• Fifth, filter by valuations. They should be deeply discounted, not just cheap. This is also a great way to minimise risk. If a stock is already trading a deeply discounted valuation, then the market has already factored in any bad news.

Checklist to Find The Best Penny Stocks

After you have filtered down penny stocks to the top 1 per cent, how do you shortlist the few you want to potentially invest in?

Well, for that you need a checklist.

Here is an evergreen penny stock selection checklist…

• Strong balance sheet: Look for low debt, high cash balance, & a current ratio greater than 1 i.e. current assets greater than current liabilities. Equitymaster's stock screener can help you find debt free companies.

• High promoter holding: The higher the better. It shows the promoter has skin in the game. Promoters buying shares from the market is a good sign. Use Equitymaster's stock screener to find stocks where promoters are increasing stake.

• Quality of the business: Ask these questions. Is it a good business? Are the fundamentals strong? Will it be around after a few years? Is it making profits?

• Cash flows: Does the business generate cash from its operations? If yes, then is it growing? How is the cash being used?

• Cheap valuations: It's always a good idea to buy penny stocks when they are cheap. Check if the stock is trading below its book value. A margin of safety of at least 20 per cent below book value is a good entry point.

Extreme Penny Stocks

There are penny stocks that trade below Re 1 per share in the Indian stock market. This is analogous to penny stocks that trade below $1 per share in the US market.

These are the worst quality penny stocks. The most dangerous kind. Such a low price for any stock means investors have given up on it.

And there is usually a very good reason for this. It's very likely that such a stock is on the verge of bankruptcy or is in the process of liquidation. This means its assets will be sold off (assuming there is a buyer) at a throwaway price.

Whatever cash is raised will be used to pay the company's creditors first. Thus, the banks will take their share of the remains before shareholders.

In most cases like this the banks too will have to take a haircut i.e. they won't get back everything they're owed. Thus, the shareholders will get nothing.

Turnaround Cases In Penny Stocks

In some cases the company does manage to recover via a restructuring of the business. In other words, it manages to avoid a bankruptcy as well as the following insolvency process where the shareholders get wiped out.

In such cases the company's shares are not worth zero. Its true value will be based on the performance of the company in the future.

This is also a big risk for investors but it's a smaller that the risk of buying shares in a company on the verge of bankruptcy.

Investors who put their money in these turnaround cases are hoping the shares are worth much more. They're betting the company will recover and won't enter insolvency proceedings.

This is perhaps the highest form of risk in the stock market: All or nothing. You will either end up with a huge multibagger penny stock or you will lose your entire investment.

Getting Started With Penny Stocks

In the stock market, penny stocks belong to the category of, ‘highest possible risk for the highest potential return'.

While they present potentially the biggest upside potential of any group of stocks, they can also erode wealth faster than any other group.

This is the reality you must accept when investing in penny stocks. Even if you have a high risk profile, we recommend not more than 5 per cent of the portfolio be invested in penny stocks.

You can start you're search with Equitymaster's stock screener to find the best penny stocks. The screener allows you to screen stocks based on your own criteria.

Investing in penny stocks is not rocket science but it requires you to practice extreme caution. On the other hand, if done correctly, picking the right penny stocks will significantly boost your portfolio's overall returns, especially in the long term.

This article is syndicated from Equitymaster.com.

(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)