Is this the way to make money from penny stocks? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Is this the way to make money from penny stocks? 

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In this issue:
» Growth or dividend stocks: Which type should you choose?
» Will RBI cut interest rates?
» Europe to dampen growth in China
» Euro crisis set to worsen thanks to oil
» ...and more!

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Investors, particularly retail investors, flock towards penny stocks with the hope of making big money out of them. Just for clarification, penny stocks are those stocks that trade at very low prices and market capitalization and are not part of any major market index. Investors typically prefer to buy into these stocks hoping that over time the stock price will appreciate and it will become the next Infosys.

But does it really mean that penny stocks can help make an investor rich?

Not really. Penny stocks are also a grey area in the market wherein operators and traders come to play. Borrowers, usually traders, use the penny stocks as a way to borrow money from lenders, usually market operators. Here's how it works. Suppose a trader wishes to borrow Rs 10 m. The operator, who already has a pet stock that he wants to promote, will ask the trader to buy Rs 9 m worth of the stock. There would be a lot of underhand work to ensure that only this trader gets the entire stock and only the operator's inventory of stock is sold. At the end of the day, the trader will sell back his entire stock to the operator for Rs 9.5 m. This way, the trader ends up getting the funds that he wanted to borrow. The Rs 0.5 m difference in the funds required and actually received is the operator's fee.

So both the operator and the trader are happy at the end of the day.

But the stock through which this transaction was done would have witnessed a sudden surge in prices. Unfortunately when such transactions are repeated often, such stocks end up seeing a huge upward rally in their prices. And the worst part is that a lot of innocent retail investors get attracted to such price increases and end up buying the shares. Eventually when the penny stock is not being "played' anymore, these investors get stuck with the stocks of these companies. And more often than not, never recovering their money from them.

There is a way that investors can safeguard themselves from such stocks. And that way is to study the fundamentals of the company that they are investing in rather than just looking at recent price data. If the company fundamentals are sound and the stock is available at attractive valuations, then go ahead and buy it. Otherwise stay away from it. The process remains the same irrespective whether the stock is a penny stock or a large cap one.

Do you invest in penny stocks? If so, do you invest on the basis of their fundamental strength or go by the movement in prices? Share your comments with us or post your views on our Facebook page / Google+ page.

01:20  Chart of the day
It is a fact that when the economy slows down, the companies in that country would be impacted adversely by it. And as a result, the companies start cutting back on their costs. One way in which these cost cuts affect us is through lower or zero pay hikes. But as shown in today's chart of the day, the slowdown in paychecks actually lags the economic slowdown by almost a year. At least in India. Even during the worst year of economic growth, i.e., 2009, the economy grew by only 6.7% while employee costs for companies went up by 26.5%. But in 2010, when the economic growth went up to 7.4%, growth in employee costs was merely 6.8%. By the looks of it, growth in employee costs lags the actual growth in GDP. If this is anything to go by, then we maybe looking at a slowdown in payscale in the next year as the GDP growth for India has again gone below 7% in 2012.

Data source: The Mint
* Data for FY12, is for the nine month period ended December 2011

Given some choices in food, would you look for something that is filling or something that is nutritious? Well, the answer would obviously be "both'! Similarly, high growth, high dividend stocks always find the most coveted place in stock portfolio. In fact rarely are such stocks available at attractive valuations. If you are not convinced look at the likes of Nestle India and Procter & Gamble. With above average growth rates, these companies have been superb dividend plays. That the growth of these companies is pretty much resistant to economic cycle adds to investor confidence in them.

However, growth and dividend rarely comes together in smaller companies. Ones with super normal growth rates carry a higher degree of risk. So, investors should be extra careful about valuations. Also you should have the ability to stomach risk if growth falters. High dividend paying stocks, on the other hand, are ones that do not need large capital investments for further growth. These tend to have high cash flows. Hence the cash is returned to shareholders in the form of dividends instead of being ploughed back into the business. Such stocks are the safer bet in times of market volatility. Thus the choice between growth and dividend stocks is for the investor to make depending upon the valuations. The latter though makes the case for long term returns stronger and more certain.

Even with inflation slowing, it is a big question mark whether the Reserve Bank Of India (RBI) will actually cut interest rates. The central bank cut the cash reserve ratio (CRR) by 0.5% earlier this year, but a rate cut may not be immediately in the offing. So in order to improve market sentiment the finance ministry is urging various public sector banks to cut lending rates. Public sector banks account for a bulk, i.e. 70% of the Indian banking industry. But, it may not be their best interest to cut rates, despite slowing loan growth. The main reason is that their costs of funds are still high. There is intense competition for low cost deposits (CASA), as most customers prefer higher yielding fixed deposits. NRI deposit rates have also soared after being freed by the RBI, and are now reaching 9-9.25%. Liquidity also continues to remain tight. The cost of funds for the industry is around 7% now. Thus it doesn't make sense for banks to cut rates and sacrifice margins until there are sure shot signs that the economy is improving and there is increased demand for credit.

After growing at a stupendous rate in the past, China's growth is set to slow down a bit this year. According to a Xiamen University and National University of Singapore joint forecast, China's economic growth may slip to 8.59% in 2012. One of the main reasons for this is the debt crisis in Europe. The debt crisis has not been completely resolved yet. This is why European markets have continued to remain subdued. Plus, China relies heavily on exports to fuel its economic growth. Thus, a slow recovery in the US and Europe is bound to have an impact on the dragon nations' GDP as well. What is more, China has also been compelled to take measures to cool the property market. This is because indiscriminate lending by banks to this sector had raised fears of a bubble forming there. Inflation had also risen to 4.5% at the start of the year. Thus, the country will have to contend with lower growth this year. Especially as it focuses on bringing inflation down and demand conditions in the export markets continue to remain weak.

Barely do you trample one cockroach in the kitchen, the other one pops out. Although applied to any kitchen, this statement wouldn't sound out of place with respect to the situation in the Euro Zone. For no sooner it managed to put a lid on problems in Greece, a fresh problem has surfaced. This one answers to the name of crude oil. As we are all aware, Brent crude has shot up by about 20% since mid-December and in fact set an all time high in Euro terms this week. That this has come at a time when consumer spending is still weak has put a big question mark over the recovery process underway in the Euro zone currently.

Not all is lost though. Taxes currently account for bigger chunk of the price at the pump than does the cost of crude and hence, some wiggle room is certainly available here. Besides, the consumption in Europe has also been on a decline for some time now. Looking at these factors, if the crude price does not inch up any further then damage would certainly be limited we believe. But the long term threat of oil price having reached the new normal and the fragile Euro Zone economy still looms large on the horizon as per us.

In the meanwhile, the Indian stock markets were trading deep in the red after opening the trade on a weak note this morning. At the time of writing, BSE Sensex was down by 277 points (1.6%). Barring FMCG (up by 0.6%) all sectoral indices traded in the negative. Asian stock markets were a mixed bag of performance. China was the top gainer while South Korea was the biggest loser of the day.

04:55  Today's Investing Mantra
"The person that turns over the most rocks wins the game. And that's always been my philosophy." - Peter Lynch
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7 Responses to "Is this the way to make money from penny stocks?"

sunilkumar tejwani

Feb 28, 2012

never invest in such stocks, instead my advise is to either find opportunity to short sell such stocks at every higher level with diligent stop losses or trade long the same way. Moral of the story: bahti ganga mein hath dho lo.

Like (4)


Feb 28, 2012

It's really shocking fact which i were not aware of.However, after a huge loss of money, i stopped buying penny stocks.
And i went for some low priced stocks under the recommendation of equity master.Some of fared really well in 2-3 years.Others dipped so much that they have become penny stocks(after going 80% to 90% down from my purchase price.How to treat them now? Should i accumulate more to average down?

Like (4)

shyamsunder khandelwal

Feb 27, 2012

dear sir, pls immediately stop you all mails

Like (4)

saby chacko

Feb 27, 2012

I do not know if you are aware that investment bankers like Morgan stanley, Merryl lynch, etc are chartering out LNG/ oil tanker ships which will only increase the prices of oil/gas under speculative trading and as long as these people are in the market, the prices are not expected to come down easily.

Like (4)

Lakshmi P Singh

Feb 27, 2012

I am a MBA International Business student. Equetymaster always keep me and my colleagues, updated.
Your team is doing a wonderful job in development of country's human resources .

Keep the great work up....

Like (4)

Kranthi Mark

Feb 27, 2012

Investing has a lot to do with common sense and personal observations. The man on the street frequently knows far more about the state of the economy than politicians, university professors and financial analysts who seldom travel, or if they do so, only from one first class hotel to another first class hotel and from one golf course to another. The pulse and vibrancy of an economy is, however, nowhere more visible than in a country's entertainment venues such as Multiplexes , Restaurants shopping centers ,vegetable markets and in country side fairs.
The problem with fund managers and financial analysts is they knew more about the subjects which creates very much apprehension for their portfolio investment , But the reality is where there is no apprehension there is no room for multi bagger returns . The more risks you take the probability of returns you derive from the investment is considerably high. Fund mangers always work within the frame work of fund objectives and compliance as limitations , if they like some interesting themes as investment avenues because of these limitations they may not be able to take part in those stock's growth stories as a part of their portfolio . But it might be in their personnel portfolio in the wife's account . But how many Fund managers would have had these stocks in their portfolios they are managing when these companies were at nascent stage , these fund managers would have taken these stocks in their portfolio when companies after monitoring the companies performance at matured level !! By the time the earnings would have factored in the stock price . So when you want to Create WEALTH and leave a estate to your family with multi bagger investment returns !! ..... If you rely on your MF,PMS you don't land up any where probably you will upbeat the SO called inflation. Unless the fund manager was versatile like Jim Roggers or George Soros who given 4200% returns over the 10 years span of the Quantum fund while S&P 500 returned just 47% from 1973 to83. If you want to create wealth you need to develop the strategy of stock picking .

If someone says I invests in stocks , in my opinion they are wrong , I invests in businesses rather than stocks , Investing in stocks involves identifying companies and shop for Quality , Value and Growth. I would like to analyse what are core ideas and analysis one required to be successful investor.
Management : Management is the life blood to the company , one needs to analyse the dynamism and quality of the Management , just observe the transition in the companies products and services , an edible oil processing company transformed as India's software services giant as WIPRO, A nylon polyester manufacturing company transformed as one of the worlds largest oil refining company with interest in various diversified businesses as RIL. we can observe a clear sheer Management brilliance in the both the companies . How effective is the management ,taking the advantage of changing economic environment and taking the company ahead with a great vision to capitalise the opportunities coming in the way is very important . ITC is the company transforming their outlook from a pure tobacco based company to a FMCG company. If the management is dynamic means it doesn't matter what type of industry and sector they operate , these managements excel in the art of creating value to the investors. Mr Laxmi Mittal known in the art resurrecting the sick steel plants to transform high margin yielding and profitable houses. where as steel as a sector cyclical in nature and bears less valuations in the market because of high gestation period , highly fragmented nature of industry throughout the world, and shortage of iron ore reserves and govt regulations on ore. But Mr Mittal succeeded in the process of consolidating the industry and creating value to the share holders. The prime duty of the fund manager 's and investor is to figure out these kind of Managements vying to transform to cash the opportunities and desperate to create the value to share holders. In the last three years of equity market from 2005 to 2008 markets are run up from 7,000 to the current levels , most of this happened because of unlocking value from the companies and de mergers . Some times internal disputes also surprises the share holders , tussle between Mr Ambani brothers given birth to R-com, RNRL , R-capital ventures . These are the times to the corporate India's managements to start creating value rather than unlocking values. While investing in a company one should look at the management traits how effectively manages the systematic and unsystematic risks is very important .
Price to Earnings ratio : A ratio everybody speaks and try to understand ,Price to earnings ratio is the key ratio to know How a stock is trading in the market in comparison with its earnings , we can derive this ratio by dividing current market price by number of outstanding share. figuring out PE ratio is very easy by simple calculation but the crux and confusing portion to the investors is weather the current PE ratio justifies it price or not is vital. WIPRO which was trading in the band of 500 PE ratio during 2000. Capital goods as sector always enjoys high PE multiples . Historically Steel as a sector trades in low PE ratio. While tracking PE ratio one should keep in mind PE is more relating to the Earnings i.e P&L account , the current earnings growth will sustains or not one should keep in mind while assessing the PE ratio. Another way to get a peek into the future prospects of a company is by looking at its PEG or price-to-earnings-to-growth ratio. Anything under 1 is great, although staring at a 1.1 or 1.2 isn’t going to steer me away from a company. How does PEG work? Let’s say a company has a P/E of 12. And that company has projected annual earnings over the next five years of 12%per year. It would then have a 12:12 PEG ratio or a ratio of 1. If its projected growth rate is 15% per year instead of 12%, its PEG ratio would be less than 1. Fund Managers would die for such a ratio.
Price to Book value: A ratio used to compare a stock's market value to its book value , price-to-book (P/B). The “book” refers to net assets or assets minus liabilities. A P/B less than 1 either means you’re getting a great buy on the company or its assets are worth as much as shares Think about it. At a P/B of 1, the price per share you’re paying is the same as the value of the net assets per share. That means everything else you’re getting with the company is free. The business – and the profits it generates – IS FREE. The future growth of the company? Free too. A P/B of 1 or less is a phenomenal ratio. But anything less than 2 is still considered good. I like EBITDA (Earnings before Interest, Taxes,Depreciation, and Amortization) much better – and I believe EV (enterprise value) to EBITDA is a much better ratio than P/E.EV is simply the market capitalization of a company plus its cash minus its debt. It’s called “enterprise value” because that’s what you would pay for the company if it were up for sale. Investing in company is all about buying a growth at cheaper rate , there is no specific acid test to measure as we are buying at cheap or not . One more point i like from the thesis of Mr Warren buffet is Moats let me just brief about Wide Moats : How much distance can a company put between it and its competitors by being a technology, brand, or marketing leader? This is an easy concept to understand but a hard one to put it into practice .Ford and GM probably once thought their brand recognition gave them a wide and deep moat over their obscure Japanese competition like Honda (more known for motorcycles or lawnmowers than cars at that time).Wide moats creates the efficiencies and high margin variation when compare with its peer group companies . Don't invest in a company for longterm where you can't understand their business model.
Ace fund manager Mr Peter Lynch rightly said " its futile to predict the economy and interest rates " .While investing there's always something to worry about in the market, one should shut out market noise and concentrate on company fundamentals, using a bottom - up approach. Invest for long run and pay little attention to short term market fluctuations. Equity science is not a rocket science to understand , One should develop a clear idea to understand Equity science to invest in stocks without scaring the market fads.

Like (4)


Feb 27, 2012

Can you please replace "innocent" with "greedy"?

Like (4)
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