Penny stocks are those that trade at a very low price, have very low market capitalisation, are mostly illiquid, and are usually listed on a smaller exchange. Penny stocks in the Indian stock market can have prices below Rs 10. These stocks are very speculative in nature and are considered highly risky because of lack of liquidity, smaller number of shareholders, large bid-ask spreads and limited disclosure of information.
Penny stocks have a higher level of volatility, resulting in a higher potential for reward and, thus, a higher level of inherent risk. Investors may lose their entire investment on a penny stock, or more than their investment if they buy on margin, which means the investor borrowed funds from a bank or broker to purchase the shares.
The following table demonstrates the classification of companies based on their market-capitalisation rates –
Rs. 20,000 Crore or above
Rs. 5,000 Crore – 20,000 Crore
Below Rs. 5,000 Crore
Penny stocks in India are, therefore, released by companies with market capitalisation lower than Rs. 5,000 Crore.
Why it is risky?
Lack of public information- The microcap companies that issue penny stocks are not required to file reports with the regulatory authorities (e.g., SEC). In addition, these stocks are not covered by professional stock analysts from designated financial institutions. Therefore, potential investors may not find sufficient resources to make an informed investment decision.
Penny stock companies are tiny. Most publicly traded companies are large businesses that clearly demonstrate their value, which typically ranges from hundreds of millions of dollars to $1 trillion or more. By contrast, the companies that issue penny stocks are generally tiny, with even the largest penny stock company typically valued at well below $100 million.
Low liquidity- Since many of the penny stocks are traded over-the-counter, the liquidity of the stocks is low. An investor may not always be able to sell the shares at the right time. Also, the low liquidity results in low trading volumes. Thus, even relatively small transactions can cause large swings in the price of the shares.
Limited historical information- Most of the stocks of relatively young companies with limited historical information. The companies generally lack a proven track record regarding operations, products, assets, or revenues. Therefore, investing in such companies is extremely risky.
Scams: penny stock scams are commonplace in international financial history. One such popular method is “Pump and Dump”. Companies and scammers purchase a considerable amount of penny stocks resulting in value inflation which attracts other investors to follow the hype.
Features of penny stock
High-returns: These stocks provide much higher returns compared to other forms of securities. As such shares are issued by small and micro-cap companies; they have vast potential for growth. Consequently, penny stocks are risky, given its intensity of response to market fluctuations.
Low-cost: In India, penny stocks are usually priced lower than Rs. 10. Therefore, you could purchase a substantial amount of stock units from penny stock list with a small scale investment.
Why to invest in penny stocks?
People invest in penny stocks for various reasons. Since the price of these stocks is low, they don’t need to risk a lot of money to invest in them as compared to other stocks. Also, these stocks have the potential to offer higher returns than other stocks since the companies have an exponential potential to grow.
Multibagger- Some of these stocks have the potential to evolve into multi-baggers. It means shares which yield in multiples of the investment amount. If specific security reaps double its investment amount, it is called a double-bagger, and if it returns ten times its investment value, it is considered a ten-bagger.
Example: Miss carla invested Rs. 5000 in penny stocks of A Ltd., an IT start-up. Each unit costs Rs. 5. The firm bid well at the market and their penny stock value stood at Rs. 50 at the end of the FY 20-21. Miss carla then sold her 1000 shares at Rs. 50,000, thus gaining ten times the return. This stock is considered a ten-bagger.