As consumers, one factor we usually look for is the product’s affordability. “Affordability” changes from person to person. But a general rule of thumb is, “a purchase that isn’t too costly in relation to the buyer’s income or in relation to the use that the buyer can derive out of the product”.
So we want to buy the product with the lowest price, right? Well, not quite. Cheap products are usually priced so low because there is a lot of cost-cutting in the production process. As a result, the quality of the product suffers. Poor quality might be easy on the pocket when purchasing, but these products usually don’t have a long life or there are always some snags involved with them.
What we want are well-made products, available at prices that are lower than what their quality demands. (This is why we love discounted sales. After all, we get “Aam ke aam, guthliyon ke daam!”.)
We are so careful with our money when buying even the simplest, everyday items; and yet, we invest on the basis of low prices only. Why is it so? This liking for “cheap” instead of “undervalued” has earned Penny Stocks great popularity. So without further ado, let us learn about these shares.
What are Penny Stocks?
Penny stocks are shares that trade at very low prices. In the Indian stock markets, stocks worth less than ₹10 are called penny stocks. Some of the major features of these pocket-friendly stocks are:
Illiquid: Penny stocks are usually not very easily traded in the stock market. This illiquidity is caused by an insufficient supply of these shares in the market due to problems during the issue of shares.
When the company issues shares, sometimes investors don’t show enough interest in the company. As a result, very few shares get issued. As time passes, these shares experience changes in value, but not the number of shares. The lack of faith in the company’s business also reduces buyers for these shares and as a result, they remain stagnant.
Volatile: Penny stocks, due to their low prices are often seen as lucrative bets to traders. These traders often buy these shares at low prices, inflate these prices, and then sell at these increased prices to earn profits. These speculative activities lead the prices of penny stocks to be very volatile.
Lack of Historical Knowledge: Since these stocks belong to companies that have been recently formed or were listed recently, there isn’t any historical information regarding the price movement of these shares. As a result, these stocks often cannot be subjected to trend analysis for the sake of investments.
Lack of Public Records (accounts): Companies with listed shares are subject to rigorous filing requirements. This is because the funds of the general public are invested in these companies and the regulatory bodies look out for the public interest.
However, when it comes to penny stocks, the recency of the company’s listing causes much of its operational history to be hidden from public view. The lack of information is a result of the relaxed filing rules that private companies are governed under. As a result, proper investment decisions using the company’s performance as a gauge, cannot be made.
Why are penny stocks popular?
“When you hit rock bottom, the only way you can go is up.” This often seems to be the mentality of investors when they look into penny stocks. Penny stocks can be multi-baggers, but this growth in share value is often caused by price volatility due to speculations.
Fundamentally strong penny stocks do exist that can help grow an investor’s portfolio. But the popularity that penny stocks have earned is not due to this fact. People often invest in penny stocks to emulate traders. The low price is seen as a steal and investors decide to buy these shares, although they have no fundamental reason to support any upward price movement.
This is an ill-thought move as investors usually engage with penny stocks from a speculative standpoint, even though they do not share their risk appetite or investment style.
Pitfalls of investing in penny stocks
Based on what you have read so far, investors can engage with penny stocks. However, they should exercise caution while doing so. One thing investors should always be on the lookout for when dealing with penny stocks is the phenomenon of value traps.
A value trap is a name given to such stocks that look like they are undervalued. These stocks look like they are undervalued because they appear to possess features similar to undervalued stocks like low P/E ratio, low P/CF ratio, etc.
One feature of undervalued stocks that value traps do not possess, however, is a fundamentally strong business.
There are way too many penny stocks in the Indian Stock Market for one to go through individually. So what can an investor; looking to find their fundamentally strong penny stocks, do? They can go to Finology’s stock screener platform Ticker. Ticker has a free bundle called “Value Trap” that investors can use to get rid of penny stocks that look undervalued but are actually just cheap.
Why quality is important while stock picking
“What is important is to buy undervalued stocks, not cheap stocks.” This statement asks that people buy stocks that belong to good businesses and are below their fair value, not shares that are just priced low.
Shares have an intrinsic price attached to them known as their fair value. Undervalued stocks trade below their fair value. As opposed to penny stocks, value appreciation occurs because of market correction.
Whenever the market corrects itself, prices of overvalued stocks and undervalued stocks rise. Ideally, you want to pick undervalued stocks.
However, the process can be a bit exhaustive and while the Value Trap bundle will give you stocks to avoid, they still do not mention stocks that one should invest in.
For those who like some more direction in their stock-picking endeavour, Finology has another platform named Recipe for all your personal finance needs. Recipe by Finology has a segment called “Recommendations” with suggestions on various investment instruments curated by Financial Analysts to help your portfolio grow. This section has stock recommendations to help you find fundamentally strong shares that could help your portfolio tremendously. So if you want a little less “DIY” on your financial journey, visit Recipe by Finology.
Parting Words
Creating a healthy portfolio is a long process that requires patience. Giving in to “get rich quick” schemes like unreasonable trading in penny stocks will always be a bad idea. Investors might get lucky and earn from these schemes, but luck will only get a person so far.
Remember, undervalued, not cheap.
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