Retail Investors are Buying Penny Stocks by the Fistful. Here's Why You Should Not Follow Them...

In the past, we wrote to you about retail investor's liking for penny stocks. Just like a puppy chasing its tail, retail investors often chase penny stocks with both hands.

Be it a loss-making penny stock or a penny stock which is saddled with debt, retail investors don't care.

They just want to get their hands on any penny stocks because all penny stocks will probably become big in the future and give them multibaggers returns, right?

Of course not.

If you're investing in penny stocks with this mentality, we're sorry to give you a reality check.

To understand retail investor's liking for penny stocks, we thought we'll do a simple exercise that will clear all the air.

While there's no set definition for penny stocks, a stock that trades at less than Rs 100 per share and has a market capitalisation of less than Rs 10 bn is known as a penny stock.

Keep these two thumb rules in mind when filtering penny stocks.

What about a retail investor? A retail investor is someone who holds a maximum of Rs 1 lakh share capital in the company.

Now that definitions are out of the way, take a look at the below table which shows penny stocks in which retail investors went on a buying spree recently.

On the Radar

Data shows that retail investors have increased their stake in more than 1,800 penny stocks in the most recent quarter.

From the image above, apart from Vishwaraj Sugar Industries, I'm coming across all the other names for the first time.

After taking a close look at all the above companies' financials, the results were shocking.

Their historical financial performance has remained shaky at best. Revenues are not showing any trend while some companies have not been able to post a profit for years.

Also, many of these companies have high debt on their books with the latest debt to equity ratio well above the danger mark of 1.

High debt, loss making companies and declining trend in sales are the top traits in a penny stock to be avoided. These are not the qualities one should want in a penny stock.

So why then, did retail investors load up on these penny stocks?

It could be the same old ageless story where retail investors buy penny stocks based on tips or just for pump and dump.

Investing in penny stocks based on tips from friends or someone else has become mundane. Suppose you are in a train, and you overhear two people talking that a certain penny stock has huge upside as it has invested in electric vehicle (EV) business. That qualifies it as an EV penny stock.

Licking your lips, you search for the stock and on the basis of its low price, you buy certain amount of shares.

This is like playing with fire.

Pump and dump is another common thing in penny stocks where operators buy a huge chunk of shares to boost the popularity of a stock.

Once the stock comes in news for so and so reasons and starts to head higher, these operators who are already holding these penny stocks dump them for retail individuals to buy, after making a killing for themselves.

There have been many cases where social media influencers are paid money to make the stock popular by communicating with their subscribers.

Now comes the third reason. Even at times when markets overall are falling, penny stocks never go out of style.

When broader markets will continue to lick the wounds, there will be select few penny stocks which will keep going up no matter what.

Why's that you ask? It doesn't seem to matter if there's a bear market or bull market, plenty of cheap stocks will usually making new highs.

Speculation plays a leading role here. As a result, even during a crash, there will be at least a few penny stocks that just hit double or triple-digit gains.

Due to all these reasons, retail investors like the sweet rally. But little do they know that the rally will most likely be short lived.

This is precisely why we avoid such toxic penny stocks. As penny stocks are inherently riskier, you need to be extra cautious.

Only prefer penny stocks with strong balance sheet and consistent profits. They should offer some cushion by rewarding shareholders via dividends and have low debt on their books.

These kind of penny stocks are proven to ride out the bad phase and earn handsome returns when the market cycle turns.

Don't rely on any source or tip. Instead, rely on the underlying fundamentals of the company.

Stick to a process and don't panic amid the volatility.

In penny stock investing, it's very important to distinguish between penny stocks that are investment worthy and the ones that are highly speculative.

Co-head of Research at Equitymaster, and systems investing guru, Rahul Shah follows a 'crash protection' strategy for his penny stocks service Exponential Profits.

Using the strategy, Rahul has closed 29 winning recommendations in a row.

Brace yourselves for a bumpy ride ahead, dear reader.

With a clear strategy by your side, your journey can turn out to be relatively more comfortable.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...