Are you making a right choice while investing in penny stocks?

Key Highlights:

• Penny stocks are offered at a lower price
• Penny stocks provide big returns but has higher risk
• They have low market capitalisation and limited volume

There are many investment tools in Indian stock exchanges and one of them is penny stocks. These are stocks which trade at very low price and have low market capitalisation. They are offered in the range of Rs 1 to Rs 10 and have a market value less than Rs 100 crore.

Interestingly, there are a few odd gems among penny stocks which provide heavy gains right from 100% to 3000% if identified rightly by investors.

When FY18 began, it was known that there were over 1,800 stocks on the BSE which were trading below Rs 10 and have delivered up to 20,000% return over the past seven years.

Usually small investors who adapt this platform believe that a stock trading at Rs 3 has higher chance of becoming Rs 30 - giving over 10 times return, in comparison to the stocks quoted at Rs 300 which they find it harder to become Rs 3,000.

While investing in penny stocks, one forgets that every company, which has low price, will not provide you high value.

Investing in penny stocks is like gambling, because you are betting your money in a company with no fundamentals in the hope of earning higher returns.

These stocks are highly speculative stocks of small companies which have limited cash and resources. They often have high-risk investment with low trading volume and less attention from investors.

A study by ICICI Direct said that there is only a 42% chance that an investment in penny stocks will yield returns, that too if you can hold it for at least three years. On the contrary, 86% of stocks priced above Rs 1,000 made money for investors in the past three years.

Therefore, you need to remember a few facts while investing in penny stocks.

As per Multibaggerstocks blog, first risk of investing in penny stocks is that their fundamentals are not very well. The investor has no access to proper research reports. Even the credibility of audited accounts can be questioned.

Secondly, they have extremely low volume of shares traded - which means they are easy target for unscrupulous operators to manipulate the price of the stock by cornering a large quantity of the stock and sending the price to soar or dumping a large quantity and compelling the price to plunge.

While one would think that share prices of penny stocks are low, but keep it in your mind that they aren’t necessarily cheap. In fact, most of them trade at very expensive valuations and some do not even have a PE ratio.

According to a SAMCO report, suppose XYZ Company is an index stock trading at Rs 2,000 and on the other hand penny stock PQR corp. is trading at Rs 5. Here one should look for value of these stock rather than the absolute price of the shares.

It may be noted that some great companies may also be trading at single or double digit prices due to smaller face values but they are essentially large companies with large capital structures and market capitalisation and not essentially penny stocks.

Other risk is that the Stock Exchanges namely Sensex and Nifty imposes upper and lower circuits on the companies to prevent excessive speculation in them. Such imposition of a UC or LC on the stock can adversely impact the ability of the trader to exit the stock when he or she wants to.

Penny stocks are often used by their operators, stock brokers and owners for  raising bogus long term capital gains and tax benefits. Therefore, these penny stocks get delisted as they are always under the scanner of market regulator Securities and Exchange Board of India (SEBI) and IT-department.

In an probe report submitted by Sebi in 2015, the income tax department by end of FY17 has identified about 64,000 entities which evaded taxes to the tune of Rs 38,000 crore in penny stocks. Recently, the Prime Minister's Office  has reportedly apprised the Central Board of Direct Taxes (CBDT) of 80 penny stocks.

So if you are think of investing in penny stocks, check that the company must have a business of a few years with promoters holding reasonably 30-40% minimum in these stocks.

Data of their financial credentials like revenue, Ebitda, debt-to-equity ratio, earnings per share (EPS) and price multiples must be visible. These are a few facts to indicate the health of a business to say that it would be a potential stock.