What are penny stocks
The phrase “penny stocks” was invented by the west to describe equities that are traded for less than a $1. In the Indian context, any stock that is traded for less than Rs. 10 is considered a penny stock.
There are hundreds of firms traded on the stock exchange every day, and equities with a low market value and a huge volume of shares available to trade are almost always priced low. As a result, these equities might be classified as penny stocks.
The reason penny stocks are attractive is because of their low price. Investor’s can buy a large number of shares for an effective price. One can accumulate shares in 1000+ quantities on a penny stock.
Before deciding whether one should invest in penny stocks, it is evident how to choose the right penny stock and this blow will explain the things see before picking the right stock and the things one needs to avoid.
Why are penny stocks attractive
Penny stocks are cheap
One of the things that attract penny stocks is the price band. We are psychologically attracted to the things that are cheap. People still today do not have the right skill set to choose stocks. Also, people have this belief that their penny stock will trade with a good price in the near future.
Some other things can be stores in the media that show “how a Rs. 2 stock touched Rs. 300 in one month” falsely influence people about equity investment. As a result, investors are always in the fear of missing out and participate in the cheap stocks.
People bet with high expectations
Expectations of turning a millionaire overnight is the reason why people are still falling for penny stocks. In fact, people get influenced by the success stories of famous investors and want to replicate the similar model in their lives.
Investors want to get rich quick and want to 100X their capital in months, and hence find penny stocks as the most appropriate way to grow.
Penny stocks are highly tipped
The reason penny stocks are highly tipped is because these set stocks are easy to manipulate. As per the guidelines of SEBI, stock manipulations are an illegal activity, but it is still practiced and most of the innocent investors lose their capital falling for the trap.
Since the market cap of these stocks are low, it become easy for marketers to manually increase or decrease the stock price.
I will be sharing some articles on stock manipulations and pump and dump schemes and how one can avoid falling for these traps. Thus, subscribe to my newsletters to receive my latest blogs in your email
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Choosing the right penny stocks
Here are some of the things one needs to look at before investing in penny stocks to increase the probability of fetching better returns:
Looking beyond the fundamentals
If the fundamentals of the company were in a good shape, trust me that stock is bound to be trading at high valuations. Firstly, everyone is a part of this market, and just you there are many people out there hunting for better stocks to invest.
Try looking for penny stocks that are currently having poor fundamental. Also make sure that these stocks are expected to get better in the near future. These are the class of stocks that are more likely willing to fetch you better return over time.
One needs to have an eye to look beyond the numbers and try identifying a pattern that can be a probable factor for the company’s growth.
As over time, these fundamentals will get better, making the company recognize by fellow investors and thereby pushing the stock to higher price.
Some of the things one may consider looking in a penny stock:
- What does the company actually do?
- What are the revenue sources of the company?
- Some history about the company and the founders.
- Demand of the product in the future.
Understanding the core principles of the company
A companies mission and vision talks a lot about the future of the company. In fact, one needs to understand why is there an existence for the company and what are the companies future prospects.
Keeping an eye on the promoter holding
Promoter holding can be defined as how percentage of the company is in the hands of the founders of the company. Thus, if one sees a trend that the promoter holding is increasing year on year, it can mean that the company is bound to come with better financials in the future and the promoters would like to take benefit of the same.
Another advantage of higher promoter holding is that these stocks will be in possession of the promoters which will create a scarcity of tradable share in the market. This will drive the prices even higher due to limited supply of shares.
Try using discounted cash flow method
Discounted cash flow method is a way to price the stock based on the returns it is bound to give in the future. The investors research and identify the future revenue of the company and price the stock today.
Do read this article by Investopedia to know more about the discounted cash flow valuations
I will be writing a separate blog on DCF (Discounted Cash Flow) form of valuations and share my tips and tricks I use to find the intrinsic value of shares and companies, so do subscribe to my newsletters to receive latest notifications via email.
Involving with the management
The best way to involve with the management is by voluntarily participating in the AGM (Annual General Meetings). These meeting are held once a year and are a great way to ask your questions directly with the management.
Investors can get their answers which can help them gauge the company and its future in the hands of the said management team.
Involving with the management makes sense only when one is willing to invest a large portion of capital in the stock are looking for information beyond the public domain.
Think long term for penny stocks
Stocks, particularly penny stocks tend to follow a path of an exponential curve. Over the first years, one might not fetch the desired returns. The stock might trade in the set boundaries.
But there will definitely be a time where investors will be aware of the stock potential and give a breakout. One needs to be thoroughly patient with penny stocks to gain the most out of it.
Avoid trading in an uptrend
This is from my personal experience. I tend to avoid entering a penny stock in the uptrend. As there can be likely scenario that these stocks are being manipulated or the stock has already reached its over valuation zone.
There are high chances for the stock to crash in these situations.
I have also seen traders pick stocks and trade even at 52 week high. Everyone has their style of investing and no one can be termed as incorrect. You needs to try and test the right approach and see what works in your favor.
Some things you should avoid
- Avoid penny stocks that have a strange chart pattern
- Do not trade in penny stocks that have zero trading activity
- Never trade using tips and recommendations
Conclusion
Summary table
| Sr No. | Choosing the right penny stock |
| 1 | Looking beyond the fundamentals |
| 2 | Understanding the core principles of the company |
| 3 | Keeping an eye on the promoter holding |
| 4 | Try using discounted cash flow method |
| 5 | Involving with the management |
| 6 | Think long term for penny stocks |
| 7 | Avoid trading in an uptrend |
My opinion
I feel one needs to invest a small portion of their capital in penny stock or micro cap companies. Large companies will only provide you decent returns, but penny stock have a higher potential to generate great wealth for long term.
Also read Why Do 99% Of The Traders Lose Money In Stock Market