What Are Penny stocks? Their Suitability And How To Invest In Them

Penny stocks are stocks that are trading at substantial discounts than their face values, either because they have had a series of unfavorable financial periods or some ill-conceived actions might have taken place with their businesses so that they are not able to perform as is expected of them. In any case they are in a territory no company wishes itself to be in, which in terms of investor interest translates into a no-go or get-out- as-soon-as-possible scenario. However, some investors see value in these stocks at these very junctures. With the inherent nature of these investments, they are at elevated risks which also makes them potentially highly rewarding investment avenues as well. Penny stocks usually are prospects for long term investments and are riskier in the short run.

In order to make an investment case it is imperative that we understand the different scenarios that leads a company to land itself in this territory. Of course, not all the conceivable scenarios can be discussed but we will try to get up to speed with a few basics so that it helps build up our investment case.

The first scenario is when the company has had a history of bad financial periods which has led to an erosion of its capital base in which case two things can happen with these companies. Either it can go bust, in which case it is recommended that an investor should get out of such a stock as soon as possible or the company enters into a restructuring exercise. A restructuring exercise could involve a lot of things, it may involve debtors converting their debt to equity, company may sell off a part of its non-core assets or may exit of a loss making vertical in order to avoid the precarious situation from getting prolonged. A company entering into a restructuring phase might represents a significant opportunity for value creation. An investor with a reasonable amount to time to spare and making reasonable efforts to put in some research will be able to see if such a restructuring exercise would be able to turn around the fortunes of a company around or if it is now even worthy of an investment.

The second scenario is a case when some major corporate action like acquisition or disposal or some unrelated 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 liabilities, may have to raise substantial capital (mostly as debt) which would again put the long-term viability of the company at risk. This is again a scenario that will put the company at discomfort with the investors. The scenario does represent an excellent investment case as the company’s operations were profitable for so long as they were, and it is a matter of time only and a possible restructuring exercise to bring the company back to its old form. This, however, still requires a study of the inter-relationships of the various business divisions of the company to arrive at an appropriate judgement.

The third scenario is when a company has significant debt on its books which is eating into its operating profits, in which case it becomes imperative for it to enter into a capital reorganization exercise. Such a scenario usually happens in two cases; first when a company has piled a huge debt over a period of time and with its operations has also started to become inefficient compared to what it should have been. Many old companies usually suffer from such malice requiring an urgent restructuring. The second case is when a company was initially formed with debt which has now grown significantly with a good operating profit but debt servicing is now hindering its pace of growth, in which case a capital restructuring will ensure the company will be able to take advantage of the growth opportunities that may be available to it.

Why to invest in penny stocks

Penny stocks can bring about wind fall gains to the investors if their bets come right. The reverse may also be the case if their bets go wrong. Usually some good research becomes the determining factor for investors making or losing money on these stocks. Here are some scenarios to consider –First- 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 information available by way of research about these stocks. The marginal value of every unit of time sent on researching these stocks or money spent on 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 gains potential of these stocks is significant; even if an investor is able to allocate a very small portion of his funds on these finds, he stands to make significant gains should his intuitions turn out to be right. Third- there is less speculative interest on penny stocks than on other stocks as there is less money to made on a beaten down stock than on a high volume, high value stock, which make penny stocks less volatile; However, the best value is derived from them in the long run.

Rules to invest

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; While these stocks can bring about windfall gains, in the same way they can also completely wipe out the investment in no time. By investing a small amount of available funds, the investor may gain significantly if the stock rises but does not stand to lose much should the stock fall. Second- one should not make an investment in more than two to three stocks of this type as the rules of diversification do not work well with such high-risk stocks. Instead, one should make an investment in these stocks as part of his overall portfolio containing large cap and midcap stocks which are well-researched and have a wealth of information available about them. 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 failing to sustain, and one could be digging a bigger hole for himself by undertaking such an endeavor. Fourth- Such investments necessitate that a constant vigil be 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 in no time.