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Why you must resist the lure of buying penny stocks

Whether or not you are a regular investor in stock markets, it is very likely that you would be getting regular SMS calls from unknown brokers pushing penny stocks. What exactly are penny stocks? In the US markets, the term penny stock is used to refer to stocks that are quoting below $1. In the Indian context, typically stocks quoting below Rs.20 are normally referred to as penny stocks while another definition is of stocks that are quoting below their par value or face value. The crux of the story is that these penny stocks are stocks of largely unknown companies with dubious business models. Here is why you should avoid the lure of penny stocks, although they may look quite enticing..


1.  Penny stocks are cheap because that is what they are worth

More often than not, penny stocks quote at a very low price because that is what they are worth. Some of the penny stocks are sold across as being attractive because they have a low P/E ratio. That can be misleading. P/E ratio is a reflection of confidence and public interest in the stock and low P/E normally means low confidence in the stock. Also in most cases, these companies indulge in creative accounting due to which the profits tend to be artificially inflated. Don’t fall for the low P/E trap.


2.  They are easy instruments for circular trading and you could get trapped

What do we understand by circular trading? Here a bunch of brokers enter into an agreement with the promoters to jack up the price of the stock by creating artificial demand. More often than not, if there are A, B and C trading in the stock then one of them will be the buyer or the seller in most transactions. However, when the markets see the stock consistently getting buying interest and price appreciation, a lot of retail investors tend to get interested. The moment the retail appetite has been built up, these circular traders exit the stock and the retail investors are left holding worthless paper in their hands.


3.  Penny stocks tend to move in successful sectors

This is where the penny stocks game becomes fairly simple. During the peak of the technology boom, we saw a lot of fly-by-night companies changing their name to look like IT companies. These companies not only managed to create interest in the market but they also managed IPOs and private placements at inflated valuations. It is only when the dust settles that you realize that you have been taken for a ride. The same thing happened to infrastructure in late 2007. As an investor don’t fall for such penny stocks and give more credence to the quality of management.

4.  Volumes can be created and vanish in a jiffy

This is something you get to see quite often in these penny stocks. You may enter the stock seeing huge volumes and even as you take a position you find buy orders getting withdrawn. Why does this happen? Let us go back to our issue on penny stocks circular trading. Most of the buyers and sellers on the counter are the same circular traders. When they see retail buying coming in at higher levels, they will just withdraw their buy orders from lower levels. That means suddenly the selling/buying order book looks skewed and invites more selling. When a handful of traders control most of the volumes, this is bound to happen.


5.  Basis risk is a big risk in penny stocks

This is again related to the previous point. What do we understand by basis risk? It is the difference or the spread between the buy price and the sell price. This is important because it adds to your cost while buying and diminishes your advantage while selling. Also you will find that such stocks are consistently in lower circuit or in lower circuit. Hence getting in and out of the stock may become extremely difficult as the volumes and the float is entirely controlled by the circular traders. Their interest will typically sustain in these stocks only time the time they have distributed their inventory of stocks among the general investors.


6.  Many of them may be shell companies and you could be probed

More often than not, such companies whose stocks are quoting at penny valuations are merely shell companies. That means there is no business left in the company or all the assets of the company may have been stripped out of the company. We saw that happen in case of Kingfisher, Deccan Chronicle and later in the case of Gitanjali Gems. Back in late 1990s, there were a lot of software companies which were just shell companies to launder more under the guise of exports. Such companies have negative enterprise value and hence buying them at any price does not make investment sense. Worse, if SEBI initiates any probe into such companies, you too may have to answer embarrassing questions.


7.  Finally, you don’t need to do that to your heard earned money
Lastly, you surely have better ways to put your hard-earned money to use than buying penny stocks. These are high risk stocks with a low probability of returns. More often than not, they are just buyer’s traps. You will be better off buying quality companies that are well researched instead of buying these penny stocks.
Remember, the market is replete with stories of attractive penny stocks and how your neighbour became a millionaire in penny stocks. But, there are also stories of how investors wagered everything on penny stocks and ended up losing it all. Penny stocks are not a risk worth taking. You can put your money to much better use. Rather err on the side of caution!

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