India-First-Global-Insights-Analysis -Sharing-PlatformIndia-First-Global-Insights-Analysis -Sharing-Platform

Want to destroy your wealth? Invest in penny stocks

, December 10, 2015, 0 Comments

Wealth-destroyer-invest-penny-stocks-marketexpress-inOften in my over two hour train journey from my house to my workplace, I over hear enthusiastic conversations about ‘hot stock tips’. Some even claim to have inside information on companies and advise others to buy these stocks. Sadly, majority of these stocks are penny stocks and many individuals continue to lose wealth by speculating on them year on year. While there is no official definition of a penny stock, a stock trading below Rs 10 is widely classified as a penny stock.

So what continues to attract so much interest in these stocks? Firstly, the majority of the people misconstrue the low price of these shares as being ‘cheap’. While the truth is the majority of them trade at astronomically expensive valuations and some do not even have a PE ratio. One can easily calculate the PE ratio i.e. The price to earnings ratio by multiplying the latest quarterly earnings per share (available on the BSE website) by four and dividing the current share price by this product. For e.g. If the current price is Rs 10 and the latest quarterly earnings per share is 0.05, then the PE would be 10/ (0.05*4) =50. So for this particular stock, you would be paying 50 rupees now for every rupee of current earnings. And in case of companies which don’t even have a PE ratio, you are essentially paying to be a part of a company which is currently not even making any profits!

Secondly, it is human greed that is to blame. Many buy, stocks trading at Rs 5 thinking that they can sell it off when it reaches Rs 10 within a short span of time, thus doubling their investments. Though this appears perfect on paper and even if a penny stock does reach Rs 10, it is difficult to sell them off as these scripts are often highly illiquid. This greed continues to elicit interest in them and people continue to lose money heeding to ‘advice’ from internet chat rooms, blogs and your co-passengers in the train!

Penny stocks are often subject to a high degree of manipulation. Availability of information is asymmetrical where a group of people, sometimes including the promoters of such companies indulge in artificial ‘pump and dump’ strategies. These groups slowly build up a substantial position in these companies, they even indulge in selling the shares amongst themselves to create an artificial sense of liquidity. They then spread extremely optimistic messages through large scale bulk messaging, internet blogs, internet chat rooms and so on. When enough interest is stimulated among the general public, these groups now have buyers for their shares and the group collectively dumps their holdings onto the unsuspecting people, who are fooled into believing that they are now part of the next multi-bagger stock. Be aware the next time you repeatedly hear highly optimistic views on a particular company.

Selling penny stocks can be extremely difficult. As mentioned earlier, even if you happen to catch a penny stock which has managed to increase considerably on the basis of ‘good news’, there is a high chance that you may not realize the current asking price and since trading volumes in these scrips are driven by speculators, there will be greater disagreements on the price front leading to large spreads between the bid and ask quotes and you may not be able to sell all of your holdings as there will not be enough buyers.

Luck is a poor investment strategy. Stock prices are ultimately driven by earnings. Investors should always remember that behind each share is a business and behind each business are the people who run it. Simply hoping that some ‘expected good news’ will drive the price higher is akin to basing your investing decisions purely on luck. The odds are stacked against you and such actions will only be beneficial for your broker who earns a commission for every trade you make and to those unethical groups of people who come together to manipulate these scrips.

Don’t be influenced by the past  ‘success stories’. The internet is full of blogs advocating investing in penny stocks by emphasizing on their previous successful calls. Some even boast that the large cap, blue chips of today used to be penny stocks initially. While statements like these are often portrayed in the wrong context and certainly look good on paper, these blogs never talk about cases where people have lost heavily chasing these companies and investors are often not warned about the inherent risks of investing in them.

So the next time you receive a ‘hot stock tip’, remember that even though the lure of a Rs 5 stock to increase to Rs 10 seems tempting, the odds of it reaching Rs 1 is even higher! And when you are bombarded with emails, smses and calls by strangers taking a personal interest in your financial well-being, it is a sign of desperation to sell you something which they want to dump and exit.