Don’t let mind-boggling returns cloud your judgment

To be sure, much of the run-up in the company’s stock price came recently on back of a highly profitable December quarter in FY22, after several quarters of losses.

Penny stocks seem to be quite popular among many retail investors, due to the steep returns that some of them have delivered. Out of all penny stocks listed on Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), the 448 stocks which have disclosed their latest shareholding shows retail investors have 20% or more shareholding in nearly 40% of them.

The lure of making large gains quickly with minimum investment draws retail investors to these penny stocks.

For the same amount of money, they can buy a lot of shares in a penny stock as say a bluechip company. For example, an investor gets 39 shares of Reliance Industries for an investment of ₹1 lakh. For the same amount, the investor would get 25,000 shares in Vikas Ecotech, a penny stock worth ₹3.85.

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Due to their low base, a small gain on the stock prices of such stocks amounts to large gains in terms of percentage. But do the rewards outweigh the risks that these penny stocks carry?

More misses than hits

An analysis of the past five-year performance of penny stocks where retail investors had high shareholding (20% or higher) as of September quarter 2017, shows that a little over one-third of such stocks delivered close to Nifty 50 index returns or higher over the last five years (see: graphic).

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However, what’s more concerning is that a large chunk of such stocks — 42% — were suspended or removed from exchanges. The suspension was either due to violations, or default on annual listing fees or restricted trading as these stocks were put under surveillance watch by the stock exchanges. Some of these were simply removed from exchanges after being suspended from a long period. One-fourth of these penny stocks lagged far behind the 71% returns (in absolute terms) clocked by the Nifty 50 Index over the last five years.

Penny stock for a reason

To be sure, there were penny stocks that delivered multi-bagger returns (more than 100%) in past five years, but this was still just one-third of the 456 penny stocks’ universe.

Hemang Jani, head-equity strategy, broking and distribution, Motilal Oswal Financial Services (MOFSL) says, “If investors punt on penny stocks just going by stocks tips on some social media platform or market rumours, they are doing nothing to reduce the probability of losing their capital in such penny stocks.”

“If they still wish to take their chances, it is important that they do some due diligence on their own to figure out what could be the factors that could lead to a re-rating of the stock or a turnaround of the company,” he adds.

Many penny stocks are available at such low stock prices today because of worsening business fundamentals. It might be due to a heavy pile of debt, disruption caused due to competition or entry of new player, or the product or service itself going out of use.

Take the case of Vodafone Idea, whose share trades at just ₹8.58. Apart from heavy debt, the stock has been beaten down due to the competitive intensity in the telecom industry after the entry of Jio. Retail investors hold about 6% in Vodafone Idea.

Deepak Jasani, head-retail research, HDFC Securities, says that several penny stocks have lost value during bad times. “Investors think that because prices are so cheap, it is unlikely for such stocks to see further correction and hence there is a margin of safety. But this is not the right understanding of margin of safety,” he adds.

Promoter competency and corporate governance standards are also things to watch in certain penny stocks. Some of these stocks are easy to manipulate due to their low volumes. So, by creating artificial volumes, prices of certain penny stocks can see sudden spurts, to allow exit for certain sets of investors or promoters.

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Not for small investors

The high-risk in penny stocks don’t make them suitable for small investors. If the investor ends up making a wrong bet, he can see a sharp capital erosion and the lack of liquidity may not even let the investor exit his position to cut losses. Penny stocks don’t see much volumes on the exchanges.

Jani of MOFSL says that penny stocks are not meant for small investors. “A high net-worth investor (HNI) can take risk with a small part of his portfolio and still make a meaningful bet on a penny stock. However, a small investor may end up putting a large part of his net worth at risk when punting on a penny stock. So, he stands to lose a lot more on such investments,” he adds.

Beyond stock prices

A cheap stock doesn’t necessarily mean an attractive stock. The cheap valuations should be seen with future prospects of the company, catalysts for a turnaround and management quality. Its balance-sheet might be weak due to high debt or high inventory, but are there indications that the management is working to repair it or looking to venture into new businesses to revive the company? If not, the penny stock is likely to remain one.

Elsewhere in Mint

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