Stocks that trade at substantial discounts compared to their face value are known as penny stocks.Â These stocks trade at such low levels either because they are going through periods of financial stress or because of some unforeseen event that may have happened or any negative news that is circulating about the company or any of its key management personnel. These are companies which, in terms of investor interest, translate into a no-go territory or if someone already holds these stocks, he will try to get out of these counters as soon as possible. Value investors with above average risk appetite, however, see value in these stocks and consider them as good long-term prospects for investment. The very nature of these investments makes them very high risk and also makes them potentially highly rewarding investment vehicles.
For a Penny stock to be a good investment prospect, it needs to be understood what the different scenarios are when a company finds itself in this territory. There can be many conceivable scenarios which could put a company into a precarious situation; for our convenience, we will discuss only a few important ones. The first scenario is when the company has had a history of precarious financial periods which has led to an erosion of its capital base, in which case two things can happen with these companies. First, either they go bust, in which case it is recommended that an investor should get out of this stock as soon as possible or the company enters into a restructuring process. A restructuring exercise could involve a lot of things, and it may involve debtors converting their debt capital to equity; the company may sell off parts of its unnecessary assets, or may get out of a loss-making verticals to get out of the precarious situation that it is in. A company entering into a restructuring phase thus represents a significant opportunity for value creation; an investor with a reasonable amount to time to spare and making some reasonable efforts to put in some research will be able to figure out if such a restructuring exercise would be able to turn around the fortunes of a company and if it fits into an investment case as of now.
The second scenario is a case when any major industrial accident has happened or some other incident like a regulatory fine or a legal claim has been imposed on the company. In such a scenario the company, in order to restore its full-scale operations or pay off the unforeseen liability, may have to raise substantial amount of debt which may put the long term profitability of the company risk; this is again a scenario that will put the company out of favor with the investors. The scenario does represent an excellent investment case as the companyâs operations are profitable as they were, and it is a matter of time only and a possible restructuring exercise to bring back the company to its old self. This, however, still requires a study of the intricacies involved and nuances related to the company to arrive at a suitable judgement. The third scenario is when a company has significant debt on its books, which is eating into its operating profits, in which it becomes imperative for it to enter into a capital reorganization programme. Such a scenario usually happens in two cases; first, when a company has piled up a huge debt over a period of time and its operations have also started becoming more capital intensive compared to what they should be. Many old and inefficiently run companies usually suffer from such malice, requiring an urgent restructuring. The second case is when a company was initially formed with debt and has now grown significantly with a good operating profit, but debt servicing is hindering its growth. In this case, a capital restructuring exercise will ensure that the company will be able to seize the growth opportunities that may be available to it.Â
Rules to invest in Penny Stocks
There are certain rules that need to be followed, however, to invest in penny stocks other than the general precaution of not to invest on hearsay. First; one should not invest a significant portion of his portfolio on these stocks; these stocks can bring windfall gains, but in the same way, can also completely wipe out the investment in no time. By investing a small amount, the investor may gain significantly if the stock rises but does not lose much should the stock retreats from the level at which it is purchased. Second; one should not make an investment in more than two to three stocks of this kind as the rules of diversification does not work well with such high-risk type of stocks. Instead, one should make an investment in these stocks as part of their general portfolio containing large-cap and midcap stocks. Third; there is no point averaging out one's investment in these stocks as a downslide is more likely to mean that the stock is sinking, and one could be digging a bigger hole for himself by undertaking such an endeavor. Fourth; such investments accentuate that a constant vigil is maintained by the investors. The high-risk nature of these stocks requires that every event concerning these stocks be given attention to and should an investor at any point of time feel that situation could only deteriorate further for the company, he should exit the investment at once.Â Â
Why to invest in Penny Stocks?
Penny stocks can bring about windfall gains for the investors if their bets turn out to be right; the reverse may be the case if the bets go wrong. Usually, some good research becomes the determining factor for investors making or losing money on these stocks. Here's the case âFirst; Since most of these stocks trade significantly below their face value, there is not a lot of investor or analyst interest in these stocks, which in turn translates to less research information available about these stocks. The marginal utility of every unit of time spent on researching these stocks or money spent on purchasing these stocks thus becomes significant, even if an investor is able to zero in on only one in ten stocks he is researching into. Second; The capital gain potential on these stocks is significant; even if the investor is able to allocate a very small portion of his funds to these stocks, he stands to make significant gains should his assertions turn out to be correct. Third; there is lesser speculative interest on penny stocks than on other stocks as there is less money to be made on a beaten-down stock compared to a high volume, high-value stock, which in-turn makes them less volatile; However, the best value can beÂ derived from them in the long run.