Penny stocks are those stocks that trade at a very low market price and have a very low market capitalization. These kinds of stocks in the Indian stock market have low liquidity and are speculative.
The stock market investors are interested in investing in penny stocks as they are low prices; they believe prices can double easily and because of a good convincing narrative.
But before investing in penny stocks, an investor should note that several key factors affect the way these stocks are traded and should have a solid understanding of the inherent risks that follow.
What are Penny Stocks?
Penny stocks are stocks of those companies which trade with a low share price and are issued by those companies whose market capitalization is less than 100 crores. But one should note that every stock having a low price does not mean that it is a penny stock. The company’s market capitalization should be small and less than 100 crores. One should note that the classification for the US and that of the European market would be different.
For example, Vodafone Idea Ltd. trades around Rs. 13, but it is not a penny stock as the company market capitalization is around 31,500 crores.
Factors to consider when picking the right Penny Stocks for Investing
1. Price Behavior
– Price behavior is one of the ways to judge whether the price is becoming or
not.
2. Change in
business - One
should also note what the changes in the business are? Is the company doing an
expansion? Or has the management changed?
Or whether revenues are growing? So, the impact of all these things can be seen
on performance. So, if we find out companies around the performance of its
business that is a penny and any type of recovery can be seen.
3. Fundamentals of the
Company - Also, checking the fundamentals of the company is
essential. Below are some of the essential fundamentals that one should check
before investing in any company:
Ø Market Capitalization
First of all, one should check the company’s market capitalization to know whether the stock falls under the small market capitalization criteria. We have taken an example of California Software Company Ltd:
As we can see, this company’s market capitalization is below Rs. 100 crores i.e. 63.37 crores. So it is a penny stock.
Ø Net Sales/EBITDA
We should check whether the Net sales and EBITDA of the company is rising or not. As in the case of California Software Company Ltd., we can see both increasing as shown below:
Ø Shareholding Pattern
Also, we should check whether the promoter of the company is increasing or not and who is the non-institutional investing in the company.
Ø Cash from Operation
We should also check cash from operations from which the company is generating its business, so in the previous quarter, the company generated cash from operations in this case:
Ø Company’s Website
You also need to study the company’s website a little bit as it will give you an idea of whether the company is genuine or is it a shell company?
Shell company means it’s not a company. It is only making us feel about its presence.
Ø Management of the Company
Checking the company’s management is one of the most significant criteria for investing in penny stocks. Therefore, one should doubt that company that does not have details of its management on its website.
Typically, good management has a LinkedIn profile on the page. If there is no LinkedIn here, then we can doubt that company.
Advantages and Disadvantages
Ø Although they
are highly volatile, they can also yield good rewards.
Ø They have the
potential of high growth in a short span and thus have become popular choices
among investors.
Ø Also, massive
profits can be earned from small invested capital.
Disadvantages
Ø
Lower
liquidity makes it difficult for the holders to cash out. When an investor
wants to sell the shares, he/she might not sell them immediately because of the
lack of buyers available in the market.
Ø
Penny
stocks are usually thinly traded.
Ø
As
there is a lack of company history, penny stocks make it difficult for the
investors to choose their purchase as such companies would possess a poor track
record or no record.
Ø
Artificial
inflation of share prices may lead to false statements regarding the company’s
situation, a form of fraud in the microcap stocks.
Ø
When
the price is falsely and sufficiently inflated, the people who are ready to
commit fraud will dump the shares and record instant profits.
Ø
The
lack of information about penny stocks to the public makes it hard to make
informed decisions about investments.
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