Ever since penny stocks like Ruchi Soya and Orchid Pharma have generated multibagger returns, many investors are on the lookout for the best penny stocks in India. Search engines on the internet are flooded with queries like:
“Which are the best penny stocks in India?”
“Penny stocks hitting upper continuously hitting upper circuits from last few weeks”
“How to find the best penny stocks in India?”
It is highly surprising that despite being well-known for destroying investor wealth for several decades, there is no dearth of investors who chase penny stocks.
In this article let\’s take a detailed look at what are penny stocks, the risks associated with penny stocks, and why it makes no sense to look for the best stocks in India for investment.
What are penny stocks and what are the risks associated with them?
Penny stocks are stocks that trade for very low prices usually single or double digits. Such stocks have very low market capitalization and low liquidity. As a result of low liquidity, there may be a shortage of buyers at times for penny stocks.
Theoretically, penny stocks appear attractive to many investors because of their low prices. So, investors assume that by purchasing penny stocks for low prices in huge volumes they can make significant profits when the stock price goes up. However, what they tend to forget is that the possibility of loss is also significantly high.
Let’s understand this with the help of an example:
Suppose an investor purchases 1000 quantities of a stock trading at Rs. 10. His total investment would be worth Rs. 10,000. If the price goes up by Rs. 10, the total worth of his investment would be Rs. 20,000. On the other hand, if the price goes down by Rs. 10, the worth of his investment would be zero.
So, on one side while the rewards are high, the risk is also high. However, the possibility of making losses is significantly high in penny stocks. Due to lack of adequate liquidity, a huge difference between buying and selling price quotes, and less publicly available information, penny stocks are generally subject to high speculation.
There are have numerous instances where penny stocks have hit upper or lower circuits for days together. Circuits are safeguards set to prevent large price movements in stock either on the upside or downside in a very short time. When the price changes above or below the limit, trading in that stock is halted.
In the long run, stock prices are determined by the fundamentals of the company. Stocks of well-managed companies, have a strong demand for their products or services, and have a strong financial background with consistent growth in sales and earnings are known as fundamentally sound companies. Such companies can withstand severe economic downturns and quickly recover when the tide changes.
Few reasons why it makes no sense to look for the best penny stocks in India for investment:
Lack of adequate information to analyze the stock
Penny stocks lack adequate disclosures, compliance, and transparent reporting systems that are mandatory for big companies. Also, since the universe of penny stocks is too large, it is not easy to find the most promising ones.
The publicly available information about the business and management of penny stock companies is very limited is not enough. At times, even information that is available about such companies in the public domain cannot be completely relied on. Hence it is difficult to see the full and correct picture to perform a detailed analysis of the stock. Many companies in the penny stock space are fairly new and don’t have much history. This lack of history is a big obstacle for even the most seasoned investors to analyze the company’s track record and management decisions during various business cycles.
Lack of adquate liquidy
As we have seen above, one of the biggest problems with penny stocks is the lack of adequate liquidity. So even an investor is to buy large quantities of a penny stock, he may be unable to sell it in the future due to a lack of sufficient buying interest.
Penny stocks are prone to manipulations
Due to their low prices, penny stocks are highly vulnerable to price manipulations by stock operator cartels. Historically, there have been many instances where penny stocks have witnessed significant run-ups without any specific reason attracting innocent investors who get trapped in such stocks at higher prices, while the operators dump the stocks.
Let’s understand this with the help of an example:
An operator cartel buys 5 lakh shares of a stock of XYZ company trading for Rs. 2. Total investment made by the operator would amount to 10 lakh rupees. The operators would then deliberately spread the word about the huge growth potential in the stock through SMS, social media, and stock market discussion forums.
A typical SMS message sent by such operator cartels would appear something like one of these:
“Buy XYZ stock in bulk quantities for massive gains in next 1 month as company’s patent for company’s unique product has been approved”
“Buy XYZ stock in bulk quantities for huge upside in next 1-3 months as ABC MNC is buying huge stake\”
These are just random samples of SMS messages used by stock market operator cartels to fool innocent investors looking to make a quick buck. Further to appear reliable, these SMS would be sent using short name codes which are close to real stockbroker names or advisory names.
Additionally, to jack up the stock price of such penny stocks, the operators resort to creating artificial demand by buying more quantity.
Finally, when the stock generates huge interest from unsuspecting retail investors, the operator cartels would then dump the stock by selling huge quantities. With only sellers and no buyers, the stock would then continuously hit lower circuits, eroding the wealth of innocent retail investors.
Bottom line: It makes no sense to look for the best penny stocks in India
Rather than looking for the best penny stocks in India, investors who wish to create serious wealth from stock markets should focus on the best fundamentally sound stocks in India. In some extremely rare cases, penny stocks generate multibagger returns due to a turnaround story. However, in most common cases, prices of penny stocks rise only due to news, speculation, or manipulation. On the other hand, by investing in fundamentally sound companies an investor can always create wealth in the long run.
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