Penny Stocks to Hold for the Long-Term

Last week we wrote to you about penny stocks. We discussed how to pick the best penny stocks.

Specifically, these were penny stocks to hold beyond 2022.

In case you missed the shortlisting process, here it is again...

• Avoid all penny stocks with a debt-to-equity ratio of 0.5 or higher
• Avoid all loss-making penny stocks
• Avoid all penny stocks with negative cash flow from operations
• Avoid all penny stocks with pledged shares. Promoter pledging should be zero
• Avoid all penny stocks with promoter holding less than 50%
• Avoid all penny stocks that don't pay dividends

Use these filters on stocks with a price less than Rs 100 per share and a marketcap of less than Rs 10 bn. These are the 2 general thumb rules for classifying penny stocks.

You will get an initial filtered list of penny stocks.

From this list, you should focus on only those sectors you think you can understand. For example, if you think pharma is too complicated for you, then remove all the pharma stocks from your list.

You now have a curated and personalised lit of penny stocks. You can now dig into this list to pick the best penny stocks to buy and hold beyond 2022.

You will do this by applying the following fundamental filters...

• Last 10-years sales and profit growth greater that 10%
• Cash on the books greater than total debt
• Current ratio greater than 1. Ideally greater than 2
• Return on Equity greater than 12%

This step-by-step process will get you started in your hunt for the best penny stocks to buy and hold beyond 2022.

If you have diligently followed this process, you will end up with a concise list of penny stocks.

Next you need to perform due diligence on these companies. While doing this be sure to pay close attention to the promoters. Check for any issues related to corporate governance and integrity.

After doing your due diligence, if you don't find any issues, you can go ahead and invest in these stocks.

Be sure you don't pay an expensive valuation. As a thumb rule, a PE ratio under 20 is acceptable.

But then what? Can you hold these stocks for the long-term? Or will you have to sell them after a few years? What if these stocks shoot up in a few months? What if they crash?

There are not easy answers to these questions. In this article, we will look at process you can follow if your goal is to create long-term wealth with penny stocks.

Embrace Uncertainty

The most important thing about holding penny stocks for the long term is accepting uncertainty.

You see, large companies offer a degree of certainty to investors. Large companies are usually stable. They have built this stability over many years and decades.

In these companies, most of what happens in one quarter won't change in the next quarter. The internal systems and key employees will keep the company running. This will be true in good times and bad.

Investors largely don't care about these systems. As long as the company delivers growth, they will hold on to its shares.

That's not the case with tiny companies. And most penny stocks are tiny companies. Their numbers for sales, profits, assets, cash flows are all tiny.

Long-term investors will only consider investing in them only if they think these numbers will get a lot bigger in time.

But that's just the problem. To increase its sales, profits, assets, and cash flows, a tiny company needs to first develop reliable internal systems. They also need a solid leadership and management teams.

This doesn't happen overnight. It takes a long time to build these systems and acquire critical talent.

And while tiny company is putting these in place, it's vulnerable to a lot of shocks...

An important customer might cancel a large order. A crucial vendor might demand a change in the supply contract. The workers at the plant might go on strike. The government might demand issue a notice for a plant shut down due to environmental reasons.

There are many more. All these issues can cause a severe crash in the stock.

But large companies can handle these issues. After all, they have handled them in the past.

They have contingency plans. They have key people in place to respond quickly. They have backup staff and suppliers. They have diversified their sales so the loss of one customer doesn't hurt much.

And the market knows this.

That's why a lot of adverse news doesn't impact the share prices of largecaps too much. They may fall for a day or too but then these stocks recover.

It's the opposite in the case of penny stocks.

If you're holding penny stocks for the long term, be prepared for huge volatility in the stock price.

Follow the Management's Moves Closely

In large companies, systems guide people. In tiny companies, people build systems.

Leadership and management matters much more to tiny company than to a large company. Even small decisions can have a significant impact.

This is why you need to follow the management's every move carefully. If you think they have or will made a wrong move, you should reassess your holding.

It's not worth holding on to a penny stock when the management is doing something stupid or unethical. As soon as the market get a whiff of it, the stock will crash.

On the other hand, if your penny stock turns into a huge multibagger over the years, the management will be almost solely responsible.

They can make or break the company. So follow their every move. Read everything they say in the media. Attend the any investor meeting held by the company. Attend the AGM and ask detailed questions prepared in advance.

When it comes to penny stocks, every bit of information is important.

Check the Financials Regularly

Once every 6 months, look at the financials again with a fresh perspective. You will surely learn something new.

Now 6 months is usually, not long enough to see big fundamental changes in a company. But this is an important exercise for penny stock investors. It will keep you up to date with the latest developments.

You might spot a small but important change in the balance sheet. Something might be amiss in the cash flow statement. A new line item may have appeared in the income statement.

Take in everything. You might realise something important you didn't know when you first invested in the penny stock.

Patience is the Key

Rome wasn't built in a day. And neither are multibaggers.

It's ironic that most people who invest in penny stocks do so in the hope to make fast profits when they can multiply their investment in the long term.

Penny stocks are your best bet in the market if you're looking to create life changing wealth. But the process takes time.

Over a 10-year period, the share price of Balkrishna Industries went up 30 times. In 2011, it was a penny stock trading at around Rs 90. In 2021, the stock hit Rs 2,700.

This is just one example among many in the Indian stock market. But the question is - How many investors held the stock for these 10 years?

This is what you will need to do as a long-term investor in penny stocks. Be prepared to hold the stock for 10 years or more.

If you have done everything mentioned in this article, then your patience is likely to be rewarded with life-changing returns.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.