The Art & Science Of Investing In Penny Stocks

Most investors ignore Penny Stocks on the assumption that they are not worth any attention simply because they trade in single and double digits. They are also exposed to high volatility and the chances of small businesses collapsing like a house of cards are high. However, there are also instances of investors growing their wealth on the basis of penny stocks. The article goes deep into the realm of such stocks to give a clearer picture 

Just as all big things start small, the same stands true for investing too. Some of the best return-generating shares started out very small with their price valued in single or double digits. In other words, they started out as what the investment world calls ‘penny stocks’. As businesses grew in size, many of their shareholders grew in wealth along with the companies. A recent example is that of CG Power and Industrial Solutions. The shares of this company, trading in single digits at the start of February 2020 have rallied 4,716 per cent in the last three years. 

The stock of the heavy electrical equipment maker, which closed at ₹ 8.78 on February 2, 2020 ended at ₹ 408.65 on August 16, 2023 on the BSE. An amount of ₹ 1 lakh invested in this stock at that time would have turned into ₹ 47.16 lakhs today. In comparison, the Sensex has risen by around 70 per cent during the period or ₹ 1 lakh would have turned to only ₹ 1.7 lakhs. Often stigmatized as the outcasts of Dalal Street, penny stocks have earned a reputation for leading many investors, especially the smaller ones, into financial ruin within the unpredictable and highly volatile realm they represent. 

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Thus, engaging in investing in these stocks is often deemed a risky and uncertain venture and yet, paradoxically so, a few sets of investors have soared to astonishing heights of achievement within this domain. The reality is that penny stocks have garnered an unfavourable image due to being a complex financial realm that frequently results in losses for inexperienced investors. This negativity often arises from a lack of understanding, fostering a fertile ground for misconceptions. These stocks belong to companies that tend to fly under the radar of major network coverage. Because they are seldom discussed by prominent Dalal Street figures on television shows, they fail to receive recognition as credible investment opportunities. 

The broader public typically shuns these seemingly worthless enterprises that may lack tangible products or services with only risk-taking speculators seeking the allure of discovering the next Infosys. Penny stocks occupy a unique corner of the financial landscape, often overlooked by the masses, yet brimming with potential for consistent gains if one delves into its nuances. It’s akin to a hidden path on Dalal Street where shrewd investors have managed to thrive, operating discreetly amidst more mainstream financial avenues. Penny stocks resemble the untamed frontier of Dalal Street, offering opportunities aplenty for those willing to navigate their complexities. Are you prepared to explore? 

What are Penny Stocks?

Before going any deeper into a discussion of penny stocks, we will first define what they are. There is no official definition of penny stocks by regulators. Hence, going by the most conventional wisdom, we will take only one criterion to define penny stocks and that is price. So, all the companies irrespective of their market capitalisation will be considered penny stocks till the time their share prices get into higher than single or double digits. 

Current Penny Stocks

As of August 18, 2023, there were approximately 1,750 stocks listed on the BSE that can be categorised as penny stocks, given their trading price falls below ₹ 100. At the commencement of the financial year, this count surpassed 1,900 with nearly 150 companies witnessing their prices surging beyond the ₹ 100 mark within the past four and a half months. Our analysis accounts solely for stocks that traded on both days of the year, thereby excluding stocks absent due to IPOs or those that were not traded on those specific dates.

In addition to their lower prices, penny stocks also exhibit a considerably lower average market capitalisation. On an average, their market capitalisation is merely one-hundredth of that found in non-penny stocks. To elaborate, at the inception of the financial year, the market capitalisation of non-penny stocks stood at a substantial 105 times that of penny stocks. However, this ratio has since decreased to 90 times, mainly attributable to the overall market capitalisation increase. It’s worth noting that certain stocks within the realm of penny stocks, such as Indian Oil Corporation and Punjab National Bank, possess share prices below ₹ 100, yet classify as Large-Cap stocks. 

When considering investment returns, penny stocks exemplify extremes. They possess a propensity to yield returns at both ends of the return spectrum. Our analysis of the returns from penny stocks versus non-penny stocks since the beginning of April 2023 reveals a distinct pattern. Among the 11 companies that have garnered returns exceeding 300 per cent in this timeframe, nine belong to the category of penny stocks, while merely two hail from the realm of non-penny stocks. Conversely, the inverse holds true. In the lower echelons of return-generating companies, a mere four entities originate from the non-penny stock category. Consequently, while a handful of penny stocks do indeed shine in terms of generating remarkable returns, there are, conversely, more that result in a detrimental impact on investors’ finances. 

The histogram depicts the distribution of returns among two distinct categories of stocks: penny stocks and non-penny stocks. Evidently, the returns from penny stocks are dispersed across the entire spectrum. Noteworthy among the penny stocks are instances like Prime Industries and Sheetal Diamonds, which have recorded returns exceeding 500 per cent since the beginning of April. Conversely, certain stocks, such as Goyal Aluminium and White Organic Retail, have experienced a decline of over 75 per cent in value during the same period. In contrast, non-penny stocks exhibit more consistent returns with less pronounced extremes on both ends of the return spectrum. For many of the investors, studies of the last four and half months may not help to gauge the right performance of the penny stocks and hence we took into account the performance of 13 years to know the true nature of penny stocks. 

Penny Stocks Over 13 Years

Our recent study was conducted with a focus on data spanning from the commencement of April. To ensure consistency, we extended our examination to encompass historical data within the timeframe spanning April to March. As a result, any data corresponding to the year 2010, for instance, pertains to March 31, 2010. This approach has proven advantageous in establishing uniformity, particularly concerning other financial data linked to fiscal year conclusions, which typically align with March 31 for a majority of the companies. In scenarios involving companies with fiscal years concluding in December, we have considered the subsequent March as their fiscal year endpoint to maintain uniformity. 

For companies whose fiscal years span from October to September, such as Siemens and several sugar companies, we have retained their data within the respective fiscal year they fall under. Historically, the number of penny stocks has consistently outweighed the count of non-penny stocks, although this proportion has decreased in recent times. To illustrate, consider the situation at the onset of the year 2003, where approximately 95 per cent of the stocks traded on the BSE (including those still currently traded) were priced below ₹ 100. 

However, as we approach the start of FY23, the ratio between penny and non-penny stocks has shifted to a composition of less than 57 per cent for penny stocks and 43 per cent for non-penny stocks. The graph alongside portrays the distribution of share prices for stocks traded on the BSE across different years. It is evident that a substantial majority of company share prices (excluding outliers) were trading below ₹ 200 at the commencement of FY11. The red line within the graph serves as a marker at ₹ 100. Notably, from 2010 to 2015, the majority of stocks (or the three quartiles) were trading below the ₹ 100 mark. 

In terms of annual returns within these stock categories, our observations highlight a consistent trend: the median annual return of penny stocks consistently lags behind that of nonpenny stocks. Notably, the graph below lacks data for the year 2010 due to its status as the initial period. The calculation of annual returns spans from April 1 to March 31 each year. Therefore, for the graph depicting the year 2011, returns are computed based on the price difference between March 31, 2011 and April 1, 2010. 

The designations ‘L_100’ and ‘M_100’ are employed with L_100 signifying companies with share prices commencing the financial year below ₹ 100 and M_100 indicating those whose share prices exceeded ₹ 100. The graph showcases a consistent pattern—each year, non-penny stocks, denoted by M_100, have consistently demonstrated superior median performance when compared to penny stocks, even in diverse market conditions such as declining markets as witnessed in 2012-12 and 2019-20 as well as during market upswings like those in FY21 and FY18. 

The divergence in annual returns between these two categories conveys significant insights into the nature of returns associated with penny and non-penny stocks. Within the bar plot, the black line signifies the standard deviation in stock returns. It’s evident across the spectrum that the black line is consistently longer in the context of penny stocks, indicating a greater degree of variability in the share prices of these stocks. 

Are You Ready for Penny Stocks? 

There are some criteria that set apart those investors who look at penny stocks favourably. These include: 

◼ Resolute Determination - Penny stock trading demands resolute determination and unwavering commitment. It’s not suited for those who waver or lack dedication. To truly prosper in this realm, you must possess an unyielding resolve, along with the right mindset and awareness. Mastery of this craft takes years of dedicated effort. This trading approach is tailored for individuals seeking consistent profits within this uncharted financial landscape, all the while being fully cognisant of the inherent risks tied to various trading endeavours. 

◼ Unwavering Conviction - While self-confidence and determination are pivotal, unwavering conviction in your stock movement predictions is paramount for a successful trader. Trusting your strategy and firmly believing in the soundness of your decisions, even if they occasionally prove incorrect, are vital components of triumph. Your conviction is further bolstered by deepening your knowledge and meticulous preparation. 

◼ Embracing Fallibility - Acknowledging fallibility is essential. Being mistaken in any investment isn’t a fault, particularly if you can minimise losses when your predictions are awry. Understand that despite diligent research and a fervent desire to be accurate, being occasionally incorrect is an inherent aspect. Embracing minor losses is an integral facet of navigating the terrain. 

◼ Total Commitment - Penny stock trading isn’t a mere sprint. Rather, it’s a prolonged marathon. It’s not a casual game but a serious endeavour. Recognise that penny stocks possess the potential to alter your financial trajectory significantly. Consequently, your actions should be executed diligently and with utmost professionalism. Your hard-earned resources and promising future hinge on this commitment. Treating stocks as a frivolous pastime leads to a lack of readiness and frequent monetary setbacks. True success necessitates an unreserved dedication to learning, in-depth research and the ability to repeatedly capitalise on profit opportunities. 

The analysis above vividly illustrates that while penny stocks constitute a substantial portion of the equity market’s trading volume, their significance diminishes in terms of overall market value. Additionally, when considering returns on a median basis, penny stocks have demonstrated underperformance compared to their more substantial counterparts. However, the rationale behind investing in penny stocks lies in uncovering hidden investment opportunities. By delving deep into these companies, you have the chance to unearth a valuable investment gem. Although the analysis highlights the heightened volatility associated with penny stocks, it underscores the importance of exercising heightened vigilance when considering investments in this realm. A comprehensive and thorough research approach becomes imperative when dealing with penny stocks due to their inherently volatile nature.

Penny Stock Research 

Our comprehensive analysis spanning 13 years underscores the fact that relying solely on financial metrics may not be the optimal strategy when seeking out the best penny stocks. Applying traditional financial parameters as filters might not yield the anticipated outcomes. Our study reveals that some of the penny stocks that eventually yielded profitable returns initially exhibited negative return ratios. This intriguingly suggests that astute investors were willing to invest in these stocks despite unfavourable ratios, influencing upward price movement in anticipation of improved figures down the line. 

Special situations, such as mergers, demergers and share buybacks can also unveil substantial money-making opportunities. Take, for instance, the case we began our narrative with—CG Power and Industrial Solutions—a demerger followed by acquisition that propelled a remarkable turnaround and transformed the company’s fortunes. Often, significant investors, primarily focused on core businesses or larger corporations, tend to overlook demerged entities, leaving them undervalued and trading at subdued valuations. Arvind Smart Spaces serves as another noteworthy example. 

During its demerger from Arvind Group, the company had a market capitalisation of under ₹ 250 crore and a share price below ₹ 50. Presently, it boasts a market-cap of over ₹ 1,700 crore, underscoring the potential for transformation in value post-demergers. While good management is a pivotal criterion across all stock investments, it assumes even greater significance in the realm of penny stocks. Small companies with substantial promoter shareholding can be advantageous, provided they are accompanied by a history of sound corporate governance. Often, the calibre of the management transcends mere perception and evolves as stock prices ascend. Investing in penny stocks generally entails a long-term perspective and a belief in a company’s business fundamentals or its potential to deliver robust financial results over time. This patient approach contrasts with the more active trading, which demands greater effort. Investments can yield substantial profits as shareholders can hold on to shares over an extended period, allowing prices to surge significantly, rather than cashing out at marginal gains. This investment approach, suitable for both new and seasoned investors, enables participation in smaller companies as they are discovered and ride their share prices to impressive heights—doubling, quintupling or even increasing twentyfold. 

In addition to the above considerations, other essential attributes include companies with minimal debt burdens, adept management teams, expanding market presence, growing revenues, and groundbreaking intellectual property. These aspects demand meticulous evaluation before committing to penny stock investments. Few routes to rapid wealth creation prove as effective as investing in the right low-priced penny stocks. Remarkable companies, irrespective of size, consistently deliver impressive investment returns to their shareholders.   

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