In the equity investment arena, penny stocks are classified as companies with low market capitalization and low-priced, micro-cap stocks listed and traded on the recognized stock exchanges. We consider penny stocks to be any stock under 100 pence or GBX 100.Â The most crucial characteristics of penny stocks are that they have a low market-capitalization and they are a mostly illiquid and have large spread between the bid and ask quotes.
Liquidity is one of most important factors in equity investment and many investors ignore it quite often. Liquidity is defined as number of shares available for trading in the market on a daily basis and higher the liquidity there would be lower spread between bid and ask quotes. On the other hand, lower the liquidity means higher spread between bid and ask quotes. Also, illiquid stocks can be manipulated easily by a bunch of traders through placement of a large order- what is also known as market making.
Penny stocks are generally carrying higher risks against large-cap and mid-cap stocks because of there is a lack of liquidity, smaller number of shareholders, limited information availability and large spreads between bid and ask.
However, many a time it was experienced that many penny stocks investing have turned investors fortune and handed the gargantuan amount of return in a very small-time span, which lures many investors and that's why investors keep hunting for penny stocks.
In the US market, stocks that trade below $1 are usually considered as penny stocks. This asset class also includes shares prices under $5. As we mentioned earlier that penny stocks are highly speculative in nature but time and again it has turned fortune for many investors. For instance, if an investor owns 50,000 shares of penny stocks priced GBX 10 or 10 pence, even a GBX 10 rise in share price could deliver you 100% return in a single trading session, which is generally not possible in case of large-cap stocks, because it needed large capital to buy such large quantum of shares.
However, there is also many downside risks involved in penny stocks investing too, as market making can be relatively easy to play in case of penny stocks, one could move prices by placing a large volume orders and create a sudden spike into the stock price without leaving a clue to average investors to know whether the sudden spike is genuine or subject to market abuse.
Therefore, one should conduct a thorough analysis before adding penny stocks to their investment portfolio, and portfolio weightage should be pre-defined before creating any position because a complete portfolio exposure to the penny could be extremely risky and in case bets turned out wrong it could destroy the investor's total with negative potential to recover.
In the UK, there is one specific sub-market of the London Stock Exchange that is designed to provide capital access to the smaller companies known as Alternative Investment Market, which allows small companies to raise capital by listing their shares on the London Stock Exchange with relatively higher regulatory flexibility against those listed and traded on the main market of London Stock Exchange. Companies listed over AIM-segment of the LSE tend to be small-cap or penny stocks with highly speculative in nature, because of the regulatory flexibility provided to them.
According to data available on the LSE website, at present, there are total 872 companies listed on the AIM-segment of the London Stock Exchange, out of which 745 are UK-based companies, and rest are international companies listed and traded on the AIM segment of LSE. Â
At the London Stock Exchange, penny stocks are usually found on FTSE AIM All-Share index and the FTSE SmallCap index. Constituents of these two indices with very low market capitalization, low price and lesser availability of shares for trading are often considered as micro-cap or penny stocks.
How to find diamonds from the rough
Here we are going share some of past, back-tested strategies that worked well in case of penny stock investing. Still, time and again, hypotheses have been created, tested and discarded and often hard work invested in identifying penny gems have not always been rewarded with sheer superior returns.
- Identify fundamentally strong companies within the small-cap universe
It is very vital to screen out fundamentally strong companies through various filters within the penny stocks universe and do thorough accounting checks before calculating margins, returns and growth rates because these can be easily manipulated if accounting entries have been manipulated.
- Analyse share-holding patterns carefully
Shareholding by trusted and tested investors provides a sense of confidence that the penny stock that one is researching is not a watered-down stock and relatively there are lower chances of losses against others. Look out for any well-known marque investor, funds houses or institutional holding, those who historically proven track records of making money from penny stock investing.
- Look for penny stocks with relatively higher traded volume
Volume is another very crucial factor in penny cap investing, because the numbers of shares available for trade in an auction market will provide flexibility to the investors to enter and exit out of stock easily. Generally, one should chase penny stocks in which average daily traded volume is not less than 100,000, because below that it could be difficult to square-off your open position.
- Never place market-order
One should not go for market-orders in case of penny stocks investing, because of the large spread between bid-ask quotes. In market orders, transaction execution is inevitable, but prices could swing largely, and it will provide headroom for manipulators to conduct market abuse. Therefore, investors should always go for limit orders in case of penny stock investing because in limit orders, investors exercise the transaction at the price he wants; however, there are chances that order may not get executed.
- Never short-sell penny stocks
Short selling in penny stocks could cause unexpected losses, because of the illiquid nature of penny stocks. If an investor is unable to square-off his short position, it will go for auction and accumulate huge losses for the investors and traders. Therefore, one should always go for trade-for-trade orders, in which investors and traders place delivery orders to buy and sell from their depository accounts.
Therefore, one should be very pedantic while choosing penny stocks to trade and should conduct a thorough research work before going long or short on that particular scrip. And, behavioural control is very much required while trading in penny stocks, because of their highly volatile nature and the investor should pay attention to news and developments before rushing to trade. Also, do not trade in penny stocks on rumours because it could lead to significant losses as well.
Penny stocks investing could be a very profitable bet or it could turn to be not worthy at all; so, portfolio allocation for penny stocks should be in a very disciplined manner.