Penny Stocks - Defination, Features, Benifits And Risks

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Penny stocks are those that generally trade at very low prices and consequently have very minimal market capitalisation. They are generally illiquid and found on smaller exchanges. In India, the price of a penny stock can be less than Rs 10. Because of the speculative nature of such securities, these stocks are highly risky due to their limited liquidity, minimal number of shareholders, wider bid-ask spreads, and limited information disclosure.

Some of The Characteristic Features of Penny Stocks are:

Illiquid - Penny stocks are normally not liquid. They trade in lesser amounts compared to other stocks in the market. Any stock's illiquidity means it is difficult to find buyers and sellers of such stocks.
Return - Many people associate penny stocks with returns on investments, but it is also a misnomer. Though the low prices may represent high growth, there is indeed high risk since the prices cannot be determined by what little information is available about these stocks.
Multibagger - Some penny stocks turn into multi-baggers that return many times more than the cost of investment. For example, in the case of doubling, it is a double-bagger, and if the return is tenfold, then it is a ten-bagger. Obviously, having these in one's portfolio will increase the returns, but proper research is required to find out which of the stocks actually can be multi-baggers.
Unpredictable Pricing -The pricing of such penny stocks during the sale might not be adequate. This could result in a lower or non-existent profit margin. On the contrary, these stocks could attract a price much higher than your cost, therefore, resulting in a considerable profit.

Benefits of Penny Stocks

The advantages of penny stock investment are:

Penny stocks can be highly volatile, offering fantastic returns.
They can grow quickly in a short period of time, which might attract investors.
A mere small investment may result in considerable profit.
Most traders invest an amount as small as ₹ 10,000. This amount can buy only a few shares of a blue chip company but may purchase thousands of shares of a penny stock.
Not all penny stocks undergo sudden changes in price. The ones that do, however, can move prices substantially over days rather than years.

Risks of Penny Stocks

The major risks with penny stocks are:

Low liquidity in penny stocks makes their holders struggle to cash out.
These stocks are usually traded in lower amounts.
Share price manipulation artificially may be employed to create an impression that is at variance with the company's actual situation. The method is widely termed the "pump and dump" practice, using a form of fraud in microcap stocks.

What are Multi-Bagger Penny Stocks?

Penny stocks can give relatively quick returns. The catch, however, comes with great risk and market fluctuations that, at times, can totally wipe off the gains that you get. During a bull market, these types of Shares can give a pretty remarkable upside to your returns. Stocks that return several folds on the cost of investment are known as multi-bagger penny stocks.

One of the recent examples of multi-bagger penny stocks is Lloyds Engineering Works Ltd, earlier known as Lloyds Steels. This qualifies to be a penny stock since its share price has remained low despite all the recent growth. The price at which the penny stocks normally trade is less than ₹10/- or ₹20/- in the Indian market, and the price of this stock was ₹42.45 at the beginning of 2023.

This heavy equipment player for sectors such as steel and hydrocarbons soared over 165% in 2023. It has been seen to be robust on account of a huge surge in order intake, especially from the defence segment. Its order book stood strong at ₹8.2 billion as of June 2023, reflecting very strong performance in the market.

If you had invested ₹10,000 in 2023, your investment would have grown to approximately ₹18,800 by August 2024. Projections for 2024 suggest further growth, with targets ranging from ₹85.25 to ₹87.75 by the year-end, indicating a potential additional rise of up to 10%.

How to Find Multi-Bagger Penny Stocks?

Finding one such penny stock with the power to multiply returns involves a simple checklist.

Ensure that the stock you invest in has strong fundamentals and potential for growth over the short to medium term.
The stock mustn't be at a loss. It must have positive figures for PAT or EBITDA.
The debt-to-equity ratio should ideally be less than 0.5.
You should avoid those companies where promoters hold less than 50% of shares, as these are riskier. Similarly, stocks of companies whose promoters have pledged their shares to banks and other financial institutions, which also happen to be high-risk, are best avoided.

How Long Should You Wait for a Stock to Become a Multi-Bagger?

You can make an alpha growth with your penny stock in the near term when a sudden spike in the share price occurs. It can happen in two cases:

Favourable news hits the sector, and then a rally in the near term may happen
On a long-term basis, a company could win a contract or announce expansion into a growing sector.

You can exit during both of these scenarios. The time of your exit must be determined based on the risk you are ready to take on and the investment strategy.

Few Things Should Know Before Investing in Penny Stocks.

There are a few things an investor should watch out for when investing in penny stocks.

Strong Balance Sheet

Penny stock investments require scrutinising a company's balance sheet. Debt should always be monitored. An indication of sound business and a strong, successful balance sheet is a consistently low ratio of debt to equity, showing responsible management of finance and funding for growth. Make sure the penny stock has minimum debt implied relative to the equity.

Owner-Operators

Prefer investing in penny stocks where management holds a significant ownership percentage. Companies with high management ownership are more likely to focus on creating long-term shareholder value. You can look for those where promoters hold at least 30% of the shares to increase the chances of aligning with shareholder interests.

Long-Term Business Viability

Business viability in the long term is another important factor when selecting penny stocks. Invest in companies with viable business models and promise to show viability in the future, while companies with declining industries or revenues should be avoided. A firm with a decent business model and indicating future stability, even slow growth, is likely to yield prospects far better over the long term than others.

Income Generating

Penny stocks should have earnings; while they generally report losses, it's best when such losses are seldom. Companies that are not in the current profit must be avoided. You may not want to hear of losses from management's promises of gaining profitability at a future date. Ensure it is a pretty stable company to invest in penny stocks.

Valuations Should be Deep Discount

Finally, the principle of valuation for the penny stock should be based on a margin of safety. Find stocks that are trading at a significant discount to intrinsic value. Better still, look for those at a substantial discount to book value or those at a 20% discount relative to net current assets minus liabilities. This way, you can reduce risks and increase the potential return.

Points to Remember With Penny Stocks Trading

If you are interested in penny stocks trading, keep these pointers in mind:

Penny stocks are traded in the equity segments of the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Many online stock brokers offer exposure to such stocks.
Avoid unreliable companies that do not follow regulations. Through compliance, the company will ensure stability and integrity.
While selecting penny stocks, look for high trading volumes to avoid a problem with liquidity. An illiquid stock will see you struggling to get buyers of such stock to trade efficiently.
Beware of those firms that tout great things with nothing to back the claims. Look for solid proof of what the firm has actually achieved, the plans, or data.
Open your trade at an opportunity that presents itself and close when the target profit is acquired. This curbs losses, hence assuring your gain.
Use stop-loss orders to automatically sell your stock at a set price level to lock in profits and exit at the right time.
Read news and analyses on the companies where you wish to invest. This helps gain better information about investment decisions.

Conclusion

You can get started by investing in penny stocks through a stock broker who deals specifically with penny stocks. The online brokerage platforms give access to such stocks. Ensure that the penny stock really makes a profit and is selling at acceptable prices. Now, your profits in penny stocks depend on the timing of selling the stock. It is not for beginners, as there is a high risk. The simple tenet has to be research vigilance in choice accompanied by judicious strategic risk management with stop-loss orders.
Start investing in the stock market with a small amount and watch it grow over the years. Explore Choice to find penny stocks and other types of stocks to invest in.