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Perils of Penny stocks

I often see people who are new to stock markets completely obsessed with penny stocks. Most likely they read a piece of information somewhere describing how someone became rich overnight or heard their friend tell stories about making 500% gains in a year, etc. Everyday hundreds of questions are posted on numerous forums asking for a list of penny stocks or potential multibaggers to invest in.

These are few screenshots from the web. The list of such questions is never-ending.

List of questions associated with penny stocks
Penny stock questions

However, these people are certainly not the ones to be blamed. We are never taught personal finance in schools or even in higher educational institutes. In fact, topics related to personal finance and long term wealth creation are not covered in most of the B-schools or MBA courses as well (at least it is not covered in IIM Indore where I did my MBA from and some of the other top notch IIMs). We are taught all the business concepts in the world in order to enable us to get some of the best jobs, however, personal finance is something which is completely overlooked.

The other reason why people look for such answers is the constant feeding of misleading/ wrong information which we consume from various sources, whether it be enticing media articles, hot stock tips, get quick rich stories or tips from our banks and brokers, there is simply no dearth of it.

Let us look at some of the headlines of a few media articles. They talk about how a few stocks turned multibaggers overnight, but do not talk about the thousands of other stocks which became penniless and completely eroded investor wealth over the last few years. Moreover, hardly any article delves into the detailed reasons as to why these stocks suddenly shot up. Such headlines only serve to boost the interest of the innocent retail investors in penny stocks.

Misleading headlines on penny stocks
Penny Stocks

I am no exception either and fell prey to such enticing stocks 4 years back. I ended up investing significant capital (based on tips from the self proclaimed stock experts and of course my bank’s recommendations) thinking that I understand equity markets and I am much smarter than all the fund managers out there who struggle to make even 15% annual returns. After all so many multibaggers exist in the market, the media shows proof everyday. All the fund managers must be really foolish to ignore such stocks. This phenomena of over-estimating your ability is very aptly described by the Dunning – Kruger effect:

Description of Dunning Kruger effect
Dunning Kruger effect

The first peak where you seem to think that you know everything is also known as the peak of “Mt Stupid” and this was exactly where I was 4 years ago. However, not a single day goes by when I do not regret my decision of investing in the junk stocks. After all I am talking about losing the money for which I work so hard everyday. Today, after having gained some exposure to equity markets, I feel that I am somewhere at the bottom of the curve represented above. Equity markets are a different game altogether and it is very easy to lose money if you are not careful.

It seems I have digressed too much. Coming back to penny stocks, here is one more definition of penny stocks – they are the darlings of small investors. Every wondered why? If penny stocks are so good and possess immense wealth creation opportunities, why are the larger investors not interested in them? In fact they should be crazy about such stocks to the extent of hoarding them (after all they are so cheap and a large investor can easily afford to buy them in bulk).

Why penny stocks should be avoided
Avoid penny stocks

The very reason is that 99% of the times you would end up losing money in such stocks. They are nothing but junk which no one is buying except the innocent small time retail investor.

Whether the stock is priced Rs 5 or Rs 500, it really doesn’t matter. If it falls by 50%, you lose half your wealth in both the cases.

“But weren’t all successful companies of today penny stocks once?"

This is an argument I often come across as a rationale for buying penny stocks. However, I have good reasons to believe that this argument is completely flawed.

Yes, the best companies of today started from scratch, but when they were listed on stock exchanges many of them were already doing exceedingly well. Or even otherwise, they took years and decades to grow and reach the level where they are today. No matter what, these large companies did not become successful overnight. The stock price of all these famous companies grew gradually over the years. However, our only desire while buying penny stocks is to get rich quick. Hence the original argument that all successful companies were penny stocks once and hence we should buy them does not make much sense.

Many a times, exceptionally good but deeply undervalued companies are confused with penny stocks. There are companies which are growing rapidly year-on-year but yet to be discovered and hence undervalued with low stock price. These are very different from penny stocks which have done nothing in the last few years, have an extremely poor balance sheet and continue to make losses every year.

The reason why share price of a few such companies suddenly starts going up is that they either fall in the category of those undervalued gems which were waiting to be discovered or often a corporate action has occurred (like an acquisition – take the example of Ruchi Soya or Alok Industries). Sometimes, a completely new management comes in and turns around the company completely.

Now I believe most of the undervalued market gems are rarely (or never penny stocks in the first place. They would still have a decent market cap (a few hundred crores at least, highly profitable with increasing revenues year-on-year, low debt levels, high promoter holding, etc). And you still need to do significant research before investing in such companies. A simply google search is not going to throw up the names of such companies.

The other category is mergers and acquisitions and new management. Taking the example of Ruchi Soya again, when it was hovering below Rs 5 and facing insolvency proceedings, no one could have predicted that Patanjali would acquire it. Similarly, when Alok Industries was in the bankruptcy court, no one could have guessed that Reliance Industries would acquire a stake in it. Please note that I am not saying these are good investments now – you would have to do your research on it.

Hence, using such companies as an example to show that penny stocks can grow anytime and create money is simply meaningless. There are thousands of companies completely laden with debt which have made no profits whatsoever with insignificant market cap or very low stock price. Unless and until you are an insider, it is simply impossible to predict which of these companies will be suddenly acquired by a large group and hence shoot up. I can only wish luck to anyone trying to make such guesses and gamble their money.

I know you are still not convinced and would say that there are still a few penny stocks which suddenly shoot up even though no corporate action has occurred or no turn around story has emerged. These are mostly rigged, illiquid stocks and often part of a pump & dump scheme. Few operators would jack up the prices everyday (and convince you to buy these stocks as they are going up by leaps and bounds) and when the stock price reaches a desired level, they would start selling. By the time you realize what has happened, there would be no buyers out there and you would be left with a piece of junk, illiquid stock which you can’t even sell.

Its practically impossible to consistently buy such stocks with a perfect timing and sell them before the price starts dropping. You can be lucky once or twice but that’s all there to it. It’s a gamble where you are bound to lose. If you can consistently make money in penny stocks, I would love to know your strategies (however, I am pretty sure you wouldn’t be reading this article if you could!)

Would really appreciate if you could leave your comments or feedback. Would love to hear any counter-arguments as well.

(Disclaimer: I am not recommending or advising in favor of/ against any particular fund/ stock mentioned above. These are my personal views only. I may/ may not have positions in the above mentioned funds/ equities. This article is meant for educational purpose only).

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