Planning to buy penny stocks?

They are called 'monster stocks' by pessimists and 'affordable stocks' by optimists on Dalal Street. They are cheap but they are susceptible. They do wonders for retail investors, if they click. But they are fragile too and can crash like nine pins.

Yes, you've guessed it right. We are talking about penny stocks, a lot whose fate depends on the market movement. Here's a lowdown on what to keep in mind if you hold or are planning to buy penny stocks, particularly in this bull run.

What they are

For the uninitiated, penny stocks quote at very low prices (usually less than Rs 10) and hence possess limited downside risk. They usually quote at such prices due to losses in their operations or extremely negative perception in the market about the quality of their management.

"Excitement in these stocks happens due to turnaround or change of management. Upside potential in case of revival of a sick company or its sale to an established promoter is huge," explains Ashish Kapur, CEO of Invest Shoppe, a Delhi-based brokerage firm.

With the Indian economy doing well, many industries, which were facing tough times earlier, are now booming. Power, power equipment, capital goods, banking and metals are some industries where fortunes have dramatically turned around and many erstwhile sick companies have suddenly become profitable.

Silver lining

For an aggressive investor, analysts believe that investing a small part of his portfolio in penny stocks is a good idea. "The stocks which are fundamentally strong and where you can see a decent growth opportunity does provide for a good investment opportunity for high risk taking clients. Don't invest in any stock which are news based. It is highly advisable to do a fundamental check before investing," says Hemang Jani, senior vice-president, Sharekhan.

Examples of penny stocks, which have done considerably well include Diamond Cables, Silverline Technologies, Morepan Laboratories, DCM Financial, IFCI, Western Shipyard and Ispat Industries. These stocks have turned around and delivered fabulous returns to investors over the last couple of years. Brokerage houses believe that penny stocks should not be seen with concern as long as the investor knows that they have the potential to deliver superior returns but carry a fair amount of risk.

Says Kapur, "Penny Stocks need more research and monitoring than bluechips. Hence, you need to understand very carefully the background of the company and what the possible positive triggers are. You need to be very alert and carefully watch out for news flows on these stocks."

The flipside

These stocks carry the possibility of losing the entire money invested, in case things do not turn favourable and trading in the stock ceases or the company gets delisted. Analysts view speculative buying generated in the markets and in penny stocks as a worrisome factor. They also believe that investment in any stock, whether large cap, mid cap or small cap, is totally dependent on analysis of business, management and valuation of the stock.

"In any bull market, people just look at the happening sectors and invest in the companies related to them. For instance, as it happened in 2000 or today, earlier any company with TMT name used to flare up or in between, when ethanol story came into limelight, people just invested in the companies which had some links with that business. It is very risky," says Gopal Agrawal, senior equity fund manager, Mirae Asset Global Investment Management India
It is highly recommended that you should not look at the price of the stock but valuation. Typically in bull markets, investors get attracted to low priced stocks. However, such stocks might be a dangerous proposition. In fact, if a stock is low priced despite the markets having moved up substantially, then there has to be a reason behind it. That could include poor financial health of the company. Examples of penny stocks which doomed are Global Trust Bank, Gemstone, Bombay Talkies, Trishakti, and DSQ Software.

Strategy

Generally, penny stock investments are difficult to time. You need to be very patient as these stocks do not perform well in the current period. The turnaround in their fortunes may take a longer time than anticipated. Hence, you need a lot of patience and discipline to enjoy the upside potential of penny stocks.

Says a Kotak Securities spokesperson, "Penny stocks can be relatively easy to manipulate, especially where the volumes are not very high. You should be doubly cautious while investing in such stocks." Kapur, however, feels that investing in penny stocks is a great way of making money for savvy investors who are ready to take some risks associated with them.

"As our established blue chip companies are becoming more efficient and scaling up their operations, there are plenty of takeover possibilities of companies with good businesses or assets whose stocks are quoting at extremely low valuations. With international players eyeing opportunities in India and looking at buying businesses, which are available at cheap valuations, these opportunities, if spotted early, can fetch you extraordinary returns," he says.

There are basically two approaches to pick good penny stocks. One is to search for good fundamental stocks, which are trading at significantly low levels and have the potential to ride northwards. The other way is to look at counters, which are attracting good volumes and then select stocks which have good upside potential.

In bull markets, many counters attract volumes and price movements without deserving it. For example, as the Golden Quadrilateral project was taken up, many construction companies, which were penny stocks at that point in time, became multi bagger instantly and created significant wealth for the investors.

Also, it is important for investors to see the paid up value of the share of a company. The face value of the shares of a company typically varies from Rs 1 to Rs 10. Most people think that all stocks have a Rs 10 face value and as such, a stock priced at Rs 10 with a Rs 1 face value would in the traditional sense be actually trading at a price of Rs 100.

Says Kumar, "Shares should be analysed in terms of its price earnings ratio (the most simple valuation tool for non-professionals) rather than the price of the stock. Simply put, if one share is trading at Rs 100 and another is trading at Rs 10, but the per share earnings of the first company is Rs 20 then its P/E is 5 (that is, the stock is trading at five times its current earnings). However, if the per share earnings of the second company is Rs 1, then its P/E is 10, which essentially means that it is more expensive than the company whose stock price is Rs 100."

Owing to the complexities, they are difficult stocks to hold or sell. For sometimes, they may spell a fortune but in some cases they may burn a hole in your pocket. That's why it is said, 'penny wise, pound wise.