6 mins read . 10 Jan 2023
There is something intuitively exciting about penny stocks. We would love to buy a stock at under Rs10 and watch the stock grow 20-fold in a year. That is the stuff dreams are made of. However, as much as penny stocks sound exciting, they are also fraught with risks. There is not much research on these stocks, they often belong to out-of-favour companies and tend to be vulnerable to cornering. Despite these risks, not all penny stocks are bad and there are enough penny stocks that have some intrinsic worth. There is nothing wrong with buying penny stocks, but here are some ground rules that you must follow.
Penny stocks are for very small allocation. Don’t ever make the mistake of allocating 70-80% of your corpus to penny stocks. It should never be more than 10-15%, and that too only after doing adequate due diligence. Even if you find penny stocks outperforming, have the discipline not to overshoot this range. Taken in small quantities, penny stocks can actually create alpha for your portfolio. However, you should be worried if your portfolio returns are dependent on the performance of penny stocks. Penny stocks tend to be on the radar of the regulator, so bouts of volatility are part of the penny stocks story.
Buy and Hold may work for stocks with proven quality, track record and stature. It is unlikely to work in penny stocks. These stocks must be closely monitored for news and events and you must be flexible enough to make changes where required. Above all, never venture and average your penny stocks if the price goes against you. In the case of penny stocks, you must look at the frequent entry and exit opportunities. That could mean a slightly higher transaction cost, but that is still better than getting bogged down with these penny stocks in your portfolio.
You may wonder what kind of homework can be done for penny stocks, but there are a number of variables you can take a peek into. Don’t jump in and buy penny stocks just because some large high-profile investor was a buyer at the counter. They may have a different set of priorities and risk appetite altogether. Be wary of stocks where you see the stock alternating between the upper circuit and the lower circuit. That is a classic case of a handful of operators trying to distribute these stocks to retail investors. Talk to your broker, clients and suppliers in the market, business partners of the company etc. Avoid tips and more importantly, avoid the bandwagon mentality. Fundamentals can often be misleading and announcements can be deliberately misleading. Also, keep the trading pattern in perspective.
What does this mean? Market data can give away a lot of genuine insights about the stock, you may not get elsewhere. Check for patterns of circular trading in the stock, and be wary if you see the same names in the daily Bulk Deals list. Be wary of stocks that see sudden spurts in stock volumes. Look at the delivery ratio over a longer period of time. They give you credible cues about the quality of the penny stock. Also, keep a tab on the liquidity consistency and impact cost of the stock. These are not foolproof but can protect you.
You should be able to time your entry and exit in these penny stocks. Let me explain. Avoid penny stocks when the macroeconomic parameters are underperforming or when the Nifty and Sensex are already at peak valuations. Avoid the temptation to average penny stocks. You must either continue or exit since mean reversion never works in the case of such stocks. Don’t try esoteric stuff like deep-value investing in penny stocks. Penny stocks work best when momentum is favourable. The minute you see market momentum vanishing, think with your feet on penny stocks.
Keep it smart and keep your allocations small. The most important rule is to avoid catching falling knives. You are bound to get badly hurt.