How to Avoid Penny Stocks that are Toxic

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How to Avoid Penny Stocks that are Toxic

Feb 9, 2022

How to Avoid Penny Stocks that are Toxic

Do you own penny stocks in your portfolio?

If you've been active in the stock market over the last two years, then it's likely you do. Penny stocks have been the among the most popular stocks in this bull market.

This is especially the case with retail investors. Penny stocks have offered them a great opportunity to make money fast. And why wouldn't they take it?

After all, the pandemic caused so much disruption in our lives. Many in the middle class lost their jobs. So it was perfectly natural for them to try to make some money in penny stocks.

However, the enthusiasm for penny stocks has been far too strong. These stocks have raced far ahead of their fundamentals.

And that has brought to the fore the risks in these stocks.

Penny stocks are extremely volatile. They have the potential to deliver multibagger returns in a few months. But they can also crash is short order. Corrections of 80-90% are common in this space.

As long as the market is going up, these stocks reward investors with huge returns.

But as soon as the market changes direction, these stocks crash. Retail investors have experienced this crash recently.

If you've invested in penny stocks, it's vital to know how to filter out poor quality penny stocks.

Why?

Here's the simple fact...

Most penny stocks are toxic and just not worth your time.

They are plagued with many issues - losses, sluggish revenue growth, high debt, low promoter holding, high promoter pledging - and are not considered prudent investments.

If you invest in toxic penny stocks you're risking the safety of your hard-earned money.

Just think about it. Would you invest in a large-cap stock if the company had a history of making losses?

I'm sure you wouldn't.

So you shouldn't invest in bad penny stocks either. Just because these stocks can go up a lot is not a good enough reason. The risk-reward equation is not in your favour.

If these stocks crash, your capital would be at risk. Even worse, many penny stocks, unlike bluechips, don't recover after the crash.

We've already seen this over the last few months in the Indian stock market.

Many first time investors have realised that penny stocks are not the great investments they thought they were. In fact, they are more likely to be wealth destroyers than wealth creators.

So how do you distinguish between the two? How can identify toxic penny stocks?

Well, Equitymaster's co-head of research, and systems investing guru, Rahul Shah has the answer.

Here's Rahul's 5 point checklist to filter out toxic penny stocks.

  • First, the company in question must have a strong balance sheet.

    Very often investors think penny stocks are just ticker symbols. They ignore the business behind the stock. This is a big mistake. If the company does not have a strong balance sheet the stock shouldn't be in your portfolio.

    Avoid all penny stocks that have high debt. By high debt, we mean the debt to equity ratio should be less than 1.

    In other words, reject all penny stocks in which the debt is higher than the net worth. Ideally, the ratio should be less than 0.5.

    Also, a healthy cash balance is a big positive.
  • Second, the company's owner should have significant stake.

    Ideally, the promoters should own at least 50% of the shares. But the thumb rule is to reject all penny stocks in which the promoter has less than 30% stake.

    Also in your filter, pledging of shares should be a strict NO.
  • Third, look for long-term business viability.

    Penny stocks can deliver great returns in the short term. That's why they are so popular. But they can deliver spectacular returns in the long term. This 50 and 100 baggers.

    This happens when the company delivers good growth in the long term. For that to happen its business model should be viable. Look for companies that are likely to be around at least a few years from now.

    Reject all penny stocks in which the underlying business is not viable.
  • Fourth, the company must be generating an income.

    By income generating, we mean it must be profitable. Many penny stocks have exciting stories driving them. But are they profitable?

    If the promised profits are in the future and the companies are making losses today, stay away.

    Reject all loss making penny stocks.
  • Fifth, the stock should be cheap.

    By cheap we mean the valuations should be deeply discounted. And this is a very important point. We don't mean 'reasonably priced'. We mean cheap.

    Most penny stocks that do well, go up within a hear or two, assuming there's no bear market in between. This is because the market usually needs 1-2 years to recognise the potential of a good quality penny stock.

    If you buy a penny stock at a PE ratio of 15 and after two years the market has taken it to a PE of 30, the stock would have only doubled (assuming earnings stayed constant).

    But if you bought the stock at a PE of 5, it would have gone up 6 times!

    This is also a great way to minimise risk. If a stock is already trading a deeply discounted valuation, then the market has already factored in any bad news.

There you have it. If you follow these 5 points, we're sure you will be able to weed out toxic penny stocks so that they never make into your portfolio.

The penny stocks that pass these filters, will be the ones you should analyse carefully before making a buying decision.

Happy investing!

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