Penny stocks are an absolute favourite amongst retail investors. In terms of the Indian Stock Market, penny stocks are stocks which are trading at a price lower than Rs. 10. This low price of the stock attracts retail investors who think that penny stocks have a much higher chance of becoming a multi-bagger. However, that happens extremely rarely. In fact, most penny stocks lead to destruction of capital and that’s why most big funds stay away from them. This is exactly what retail investors should do as well.
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Here are the reasons why retail investors should stay away from Penny Stocks –
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Easy targets for pump and dump schemes
Penny stocks generally have a low share price AND a low market capitalization which makes them an easy target for pump and dump schemes. A typical penny stock which might have a market cap of a few crores is very easy to manipulate. Big funds can buy large quantities of a penny stock easily and send the stock price skyrocketing. This increase in stock price attracts retail investors who “invest” in such penny stocks. Once enough retail investors have entered the penny stock, big funds can sell their shares. Big funds get the profit and retailers get the worthless shares. This is a classic story which has been happening in the stock market for decades. Now you must be wondering, can’t every stock be manipulated by big funds? Why only penny stocks? That brings us back to the point about market cap.
Market capitalization of a company refers to the total value of all the stocks combined. E.g. a company like TCS has a market cap of over $200 billion (~ Rs. 15 Lakh Crore). So, it is very difficult to pump a share like TCS because an extremely high amount of capital is required to move such a stock. It will require a few thousand crores to slightly move such a stock which makes them much safer compared to penny stocks.
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Penny stocks generally are failed companies
Most penny stocks are penny stocks for a reason. When RPower got listed in 2008, it was listed at a price of Rs. 331 and has been falling ever since to a current price of around Rs. 10-12. Similar is a story of Suzlon which reached it’s all time high of Rs. 441 in 2008 and has been falling ever since reaching a current price of Rs. 6-8. When a company price keeps on falling because nobody wants to invest in them, a company can become a penny stock!
Another type of penny stocks are companies which have recently listed in the stock market and are very small companies who are trying to become big companies in the future. Just like any other business, most of these new companies will fail in the next decade. So, it doesn’t make any sense for retail investors to get involved in such companies which are not well established or are failing businesses. Retail investors should instead find big established companies who have built decades of reputation and trust with the shareholders. Those companies will generally not be penny stocks because they have grown over the years!
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Low media coverage
Since most penny stocks are either failed companies or small & unestablished companies, there is low/no media coverage of these companies. Now you must be asking, how does that matter? It matters because you will not get to know any key information regarding these companies! When the company declares the quarterly results, when the company has announced dividends, when the company has any corporate announcements, etc. It is very difficult to track the fundamentals of a company when such information is not readily available! And investing in a company without properly tracking it is like shooting in the dark. You might get something big but the chances are very slim. This also means that big funds who have better sources of information will be highly active in such stocks to trap retail investors because of lack of transparency!
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Susceptible to scams/frauds
Lack of media coverage is the perfect environment needed for scams/frauds to occur. Most big companies are always under scrutiny by the media and every single action taken by the company is tracked by everyone. This ensures that the big companies always follow the rules and conduct business in a very transparent manner (still scams have historically occurred in big companies). On the other hand, penny stocks which are generally smaller and unestablished companies have nobody watching over them. This increases the probability of such companies to indulge in unethical behaviour and commit fraud. Even if there is a slight hint of fraud in a company, investors lose all their trust in that company and the stock price crashes. So it is very important for retail investors to be on high alert when investing in penny stocks. Or the better option is to just stay away from penny stocks!
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Low support of big funds
Big funds such as mutual funds, pension funds, HNIs (High Networth Individuals) provide a stable backbone for any company. These big players identify a company and invest in them for a long time and companies which have a good support of big players tend to be more stable. These big funds do not like to invest in penny stocks due to all the previously mentioned reasons. Big funds know that such companies are an extremely high risk category and can sometimes be similar to gambling. So the majority of the shareholding for penny stocks are either promoters and retail investors. Retail investors are “invested” in the stock due to its low stock price and not because the company is doing well. Such retail investors are fickle-minded and will soon leave the stock when it is unable to perform. So, penny stocks keep on changing hands from one retail investor to another destroying wealth along the way.
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Penny Stocks don’t move based on their fundamentals
Penny stocks generally move based on news or are driven by big funds who want to pump and dump the stock and make quick money. Basically everyone including big funds and retail investors are in penny stock for one and only one reason – to make quick money! Nobody has invested in a penny stock because of it’s good fundamentals. This makes it extremely difficult to predict the future of such a stock because it doesn’t move based on fundamentals. Even if such a company is improving its business, it can still be a target of pump and dump schemes by big funds!
Please note that there have been some penny stocks which have become multi-baggers over decades but such cases are extremely rare. Retail investors are better off to wait for these companies to prove themselves first and then invest in the company.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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