Penny Stocks: Are they worth investing in?
Created on 11 Dec 2020
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Updated on 04 Dec 2023
Penny stocks are a known term in the market and also the fact that investors usually avoid trading in them. The common notion regarding these stocks is that they are highly volatile and not much comes out from investing in them. But a veteran in this trading world knows that many times these cheap stocks turn into multibaggers.
Penny stock is a concept that started from the west. At that time, the small public firms whose stocks were trading at less than $1 per share were called penny stocks. And the whole deal of not trading among them also has a reason. The reason being the commission charged for trading in them was relatively high in comparison to the actual price of the share. Thus, people started avoiding penny stocks.
But still, there are instances where investors proved that these penny stocks could turn into millions. Let's get to know how?
What are Penny Stocks?
In India, penny stocks have a market price of less than ₹10. And, understandably, a company will have such a low share price if it is a small-cap firm or nano-cap firm, or micro-cap firm. Since trading is less in these stocks, they are very illiquid and have a volatile market.
We know that they are from small-cap firms but exactly which firms are characterised as small-cap? The information given below may be of help:
Large Cap Firms
₹20,000 crore or more
Between ₹5,000 crore – ₹20,000 crore
Less than ₹5,000 crore
Now, the table makes it clear that any firm that has a market capitalisation of less than ₹5,000 crore will be a firm with penny stocks.
Do penny stocks justify their name?
We know that in India a share trading at less than ₹10 is classified as a penny stock, but it is actually not that cheap. The price of a stock in itself cannot exactly portray whether it is expensive or cheap. Some other parameters also need to be analysed before coming to a decision. Some of the parameters can be:
Book value of the stock
Growth prospect of the stock
Amount of debt in the books
Features of Penny Stocks
Now, if after analysis, it is found that a particular stock is indeed a penny stock, before reaching a trading decision, it is better to know a bit more about it. Let's do it by knowing its features.
Illiquidity comes from the fact that it is less traded in stock exchanges and is of companies that are not very popular. Thus, it becomes difficult to find traders who are ready to take the opposite position (buy/sell).
2. Higher returns
These firms do promise good returns compared to some other alternative investment instruments. It is so because being a small-cap firm means it will have many future growth opportunities, thus giving the stocks a chance to increase their value.
3. Lower cost
This feature is quite understandable; a penny stock trades at a low price. This allows investors to hold a good amount of stocks and that too, with a low investment amount.
Many factors make the penny stocks a risky investment, such as illiquidity, high volatility to market fluctuations, etc., but this risk is compensated with the higher returns.
Best Suited for whom?
These stocks have their advantages and disadvantages and are quite famous among some investors. It may be listed at the lowest section of BSE and NSE or even at less popular stock exchanges yet, those who want to invest in them will do so. So, the question remains, who exactly are these adventurous investors?
Generally, they are investors who are more risk-seeking than risk-averse. These types of investors care less about returns and like taking risky investments. Also, investors who trust their instincts and analysis may be confident about the fact that in the future, the particular penny stock will turn into a major multi-baggers.
Still not sure about the stocks, below are some reasons that prove that penny stocks can indeed be a good investment option.
Reasons to invest in Penny Stocks
Sometimes investing in penny stocks becomes the pure form of betting; it can be hit or miss. Hit if the firm grows prosperously in the future and miss if it is unable to face the market volatility. But looking at the brighter side, let's list some reasons to invest:
Since penny stocks are cheap, it is easy to invest in them without losing much. Owning a small section of these shares and adding it to the portfolio mix will affect neither the portfolio nor your pocket. At the time of downtrend, there will be a loss, but when the market is bullish; the return will be higher than larger and mid-cap firms.
Multibaggers are stocks that grow multiple times their initial value, and it is seen many times that penny stocks show the potential of becoming multibaggers. So who knows, a firm may be trading as a penny stock today, but in a few years it grows to be a large-cap stock. To properly identify such penny stocks, do proper analysis before investing.
Associated Risk with Penny Stocks
There are two reasons that an investor should look out for a while trading in penny stocks.
1. Price impact
There are many traders who use the illiquidity of penny stocks for earning high profits. What they do is suddenly buy a large quantity of these stocks that raises demand and automatically will increase the price of the stock. A price increase attracts more buyers, raising the value higher. After a considerable number of investors join the penny stock club, the scammers will sell their shares which will start dropping the price.
At the end of the day, the scammers will enjoy the profit whereas the other traders will have to deal with the dropping price and the loss.
2. Less public information
Since penny stocks are usually of new firms, thus there will be less information that can give help with analysing their past performance, financial stability, and growth opportunities.
So if you are interested in trading in such shares, make sure to do as much as possible research to avoid being scammed and facing losses later.
The Bottom Line
Do these stocks payoff? Just one word: Yes. It does pay off all those research, risk-taking and you going against the mainstream investments. The key is to just select the right penny stock because when it comes to returns, at times, they jump 1000% of their initial value.
Try experiencing the actual thrill of the stock market by adding a penny stock to your portfolio and see how good of an investor you have become when the stock becomes a multi-bagger. So what will it be, wild or safe play?
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