‘Cheap is the love that has a price’ can be said as the apt description of penny stocks. Beginning with the legal definition, initially penny stocks were known as stocks being traded for less than $1 per share, however, the Securities Exchange Commission has modified the definition and made the limit to less than $5 per share.
As the name suggests, they are the stocks of small and growing companies, like startups, with the main benefit of financial or investment inclusion. It has attracted the eyes of many investors primarily because they do not require hefty bank balance to invest.
Penny stocks serve the appetite of many investors who wish to fill their plate with risks, as they are highly volatile, and their prices keep fluctuating. Their prices can double in hours, while at the same time can go negligible in an equivalent time period. The reason sighted for such fast price movements is that issuer companies have limited resources with low net worth, as compared to blue-chip companies which are low-risk and high net worth, profitable companies, with sound trading history. Thus, penny stocks are profitable only for those knowledgeable investors who are backed with proper research, before putting their money in someone’s pocket.
While the entire stock market is nothing more than a game of luck, the question that arises is whether penny stocks are worth enduring such sudden ups and downs. The usual answer to this question is no because the cons quite easily outweigh the pros.
Why a NO to penny stocks?: The research before investing in penny stocks is very limited, given the small size and low-reach of the company. They do not have to submit regular financial information to the Commission and do not come severely under public scrutiny. This is because penny stocks are traded on pink sheets or Over-the-Counter, where compliance requirements are profusely less. The available information cannot be termed as reliable, thus making it difficult to make an informed decision prior to investing. Also, as these new companies have negligible or no historical track record, lack of trust serves a huge role in refusing to have penny stocks in one’s portfolio.
Due to frequent ups and downs in these stock prices, buyers may find illiquidity as a problem. If the market price is high on a day, the buyer cannot get rid of that stock unless the price goes down and it becomes attractive in the eyes of the other potential buyer, which ultimately puts the seller in a position of loss.
The only way to avoid this is to place a stop-loss order with the broker, that is, when the stock reaches a particular set price, the securities will be automatically sold. This serves as the most common precaution for minimizing losses.
Penny stock issuers are usually prey to mismanagement, often leading to severe conflicts between managers and stockholders. The managers tend to manipulate profits and often do not focus on raising the market price of shares as their priority concern. The major reason behind this comes out to be, again, the small scale of the amateur companies. ‘Buyers beware’ is said to be the principle prevailing in the penny stock market.
However, the investors in penny stocks should be familiar with the ‘pump and dump scheme’. In this scheme, the current stockholders who wish to exit at a gain, promote a stock by making a big announcement. Then, they sell the stock when the market price rises due to the positive and exciting market sentiment, at a gain. Thus they ‘pump’ the price of the stock, followed by ‘dumping’ it. After the sale, the price falls severely due to the false high sentiment created, causing huge losses to the buyers.
It is usually said that penny stocks are traded at such low prices because that’s exactly what they are worth. The issuer company has a low Price-Earnings ratio, which is a reflection of low investor confidence and interest. Also, the issuer companies are usually ‘shell companies’, which are planning to shut down in a short period of time, like in the case of Kingfisher and Geetanjali, thus making it all the more unattractive with no future growth prospects.
Thus, I can conclude by saying that penny stocks are usually on the list of those investors who have a strong risk appetite, and are wise in terms that they can correctly monitor the stock price, and can successfully plan their exit and entry. Else, penny stocks may render an innocent investor penniless, in a short span of time.