It’s not worth running behind pennies

The fairy tale-like stories of those who made a killing in stock markets never fail to amaze.

The numbers look even more impressive if the initial investment was in a stock whose price was really low, maybe even less than ₹1.

There are many who like to invest in such low-value stocks or penny stocks, as they are also called. In India, stocks that trade at less than ₹10 are classified as penny stocks. Many investors like to buy these stocks since the number of shares that can be bought are higher, given their low price. Also, a small price increase can double or triple the capital. While the adventurous type may find this exhilarating, there are many reasons why many seasoned investors give these stocks a wide berth.

Four out of 10 penny stocks that were traded on August 28, 2014, are now sporting losses. About 15 per cent of the stocks have halved in value over the last three years. Stocks such as Nakoda and Lanco Infratech have lost over 90 per cent in value. While many were multi-baggers too, your chances of zeroing-in on them were not too good.

The fundamental flaw in penny stock investment is that it makes the stock price the basis of stock selection. Stocks should be bought based on the company’s performance and prospects, not the stock price. Now that you can buy even one share of a company if you want to, capital need not be a constraint.

You might not be able to buy MRF or Bosch or Eicher Motors, but most other stocks are available at affordable prices, especially with many companies resorting to stock splits to bring them within reach of the small investors.

Besides, penny stocks generally trade at a very low price for a reason.

One, many of these companies are likely to have been consistently recording deteriorating financial performance and this is reflected in their numbers. There were around 1,030 stocks whose last traded price was less than ₹10 as on August 28, 2017. Of these, 20 per cent had no revenue in FY17, 40 per cent had revenue less than ₹1 crore and 60 per cent had revenue under ₹5 crore. The numbers on the profitability front were even more abysmal — 60 per cent of the companies were loss-making and 80 per cent had profit under ₹10 lakh. Many of these stocks, including Moser Baer, Unitech and Jyoti Structures, have been recording losses for many years now. Due to repeated loss-making years, many of these companies sport negative net worth.

Many of these stocks could also have been beaten down due to governance issues. Cals Refineries, for instance, that trades at 0.10 paise, was found guilty by SEBI of defrauding investors in its Global Depository Receipts (GDR) issue in 2013. The regulator had pointed out that the company had facilitated unjust enrichment of its promoter at the expense of investors and the company’s actions were fraught with malafides at every stage of its execution. Similarly, Rasoya Protein, whose stock trades at 0.16 paisa, was also barred by SEBI, along with four directors and five other entities from the capital markets for alleged fraudulent activities in its GDR issue. Many of the penny stocks such as Winsome Diamonds, REI Agro and Zylog Systems also feature in the RBI’s list of wilful defaulters.

It is also possible that many of these stocks are shell companies with almost no operations. Earlier, lax regulations had allowed many promoters with dubious reputation to raise money through initial public offers. The company would record repeated losses after listing, helping the promoters siphon off all the money. If we consider the recent list of suspected shell companies sent by SEBI to exchanges, almost a third of them trade at less than ₹10, and can be classified as penny stocks.

Lack of liquidity is another problem that investors in these stocks face. Many stocks such as Hind Securities, Kalyanpur Cement and Heera Ispat have seen no trades over the last four months. Even if you go ahead and buy such stock, exiting them would be quite difficult as there would be no counter-party when you try and sell the stock.

Two, low liquidity makes them the favourite haunt of price manipulators. For instance, Dwarikesh Sugar that was a penny stock in 2014 has raced to ₹64 now. But speculative activity in the stock has also increased manifold, making it too risky for small investors.

While the overall picture does look grim, there is one category of penny stocks that you can look at, provided you have the patience to wait and deep pockets to weather losses if the bet does not work. These are stocks of companies with good management that have run into bad times due to adverse business conditions.

If you believe that business conditions could improve, then you could bet on these stocks. Some stocks belonging to cyclical industries such as sugar and steel are a case in point. However, while selecting stocks to bet on, make sure to check the management, financial performance, liquidity and run a check on governance issues.

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