Cats and Dogs

Can you make a killing buying cheap (penny) stocks?

This is an article written by Deepak Mohoni for India Today. We will update the statistics to include more recent events shortly. However, the findings and the conclusion are unchanged.

Anyone looking for a low-priced stock in the Indian stockmarkets will face no difficulty in finding one. Over 60% of the shares traded at the end of March 1999 were priced below Rs. 15 on the Bombay Stock Exchange. And this was four months after a bull market had been in existence, with the sensex up about a thousand points from its November 1998 low of 2,741.

Any investor would love to own a “penny stock” (to borrow the term from Wall Street) which is set to shoot up. The profits to be made on such stocks, after all, are tremendous. Penny stock enthusiasts will easily point out several instances of stocks which have risen five-fold during this calendar year. But is there really a fortune to be made on such stocks?

The answer, unfortunately, is no. While a few investors may get lucky and make a killing on a couple of stocks, the majority who try their hand at playing penny stocks will lose money sooner or later. To understand why this is so, let us take a look at the behaviour of these stocks.

The most important point to bear in mind is that if a share is cheap, there is usually a good reason for its low price. These are not the stocks into which the smart money flows at the beginning of a bull market. After the sensex bottomed out at 2,741 at the end of November last year, it gained 22% in the next six weeks. During this time, only 4% of the stocks priced below Rs. 15 improved in price.

One of these – Krypton – made an apparently spectacular gain of 4900%, but this was because it started off from a price of just 5 paise! Trading this stock (and many others like it) would have been next to impossible, as the daily trading volume rarely exceeded 2,000 shares during the stock’s spectacular rise.

However, by the time a bull market is 2-3 months old, a noticeable number of cheap stocks have appreciated five-folds or more, and this is what captures the imagination of a few investors. Low-priced stocks are also not “constrained” by the 8% price rise limit imposed by the circuit-breaker system, making them apparently even more attractive.

The trouble is that not all penny stocks are set to rise and remain at high levels. As pointed out earlier, despite a four month old bull market, three out of every five traded stocks are still below Rs. 15. In fact, nearly 40% of them are even below Rs. 5. The odds of catching a stock which is set to rise are therefore stacked up against the investor.

Another problem arises due the relative inactivity of the stock, which makes it possible for the share price to be easily “manipulated”. An operator could be deliberately bidding a higher price to make it appear to be on a rising track.

The “bull run” in such stocks typically ends with a bull market. Trading volumes dry up, and it is virtually impossible to get rid of the stock once a bear market is under way. The stock then gives back all the gains it made during its brief ascendancy. As most investors who buy such stocks do so closer to their peaks than their bottoms, they end up making big losses.

The previous bull market and the bear market that followed illustrate this point. The sensex enjoyed a brief bull market that took it up from 3,164 on 29 Jan 98 to 4,322 on 22 Apr 98. During this time, a little over 250 stocks priced below Rs 15 at the start of the bull market at least doubled in price. However, by the end of the year, only 16 of these 250 were priced above Rs. 15, with the rest having hastily returned to their starting blocks or worse.

We are now at a stage where the present bull market is being tested. The sensex had plunged 4.5% in a single session on Apr 5 following the news that the ruling BJP-led coalition was on the verge of losing its majority in parliament. Such large falls have in the past spelt the end of bull markets, and investors should avoid penny stocks like the plague at this juncture. In fact, this may be a good time to unload such stocks, as there may still be some residual demand for them.

It must be mentioned that there are rare bull runs when stocks of every description begin to rise sharply without much reason. This usually happens when the “public” enters the market in a big way, typified by the panwala giving tips to his customers. We saw such an occurrence when the sensex soared from under 2,000 to over 4,500 in the first quarter of 1992, and we will probably see it again when the sensex crosses 5,000 or 6,000. Even under such circumstances, penny stocks remain a dangerous investment option.