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These stocks up 100%. Be cautious not happy!

Sep 6, 2010

'Every 8th penny stock has doubled in the last 8 months', screams the headline of a leading daily. Before we go any further, it will be important to define what a penny stock is. As the name suggests, a penny stock is one that can be bought for a very low amount. Now, there is no fixed criterion of how low the amount can be, just as there is no fixed criteria of what should be the ideal market capitalisation of a large cap or a mid cap stock.

The article has put the limit for a penny stock at Rs 10 per share. And this we think is quite reasonable. Thus, a penny stock is one whose one share costs Rs 10 or less. Let us go move back to the article now. The article states that if you arrange all the penny stocks listed on the Indian bourses in a straight line, every eighth penny stock has doubled in price since the start of 2010.

Now, this is something quite interesting. The broader indices like the BSE-Sensex and the NSE-Nifty have barely budged. But there have been about 63 low priced stocks out there that have doubled or gone even higher in price.

We believe that this should not be an occasion for investors to rejoice. Historically, it has been noted that whenever penny stocks have rallied, stock markets have formed a top. In other words, the rally in penny stocks has more often than not led to a correction in the broader market.

No, there is no technical angle to it as far as we are concerned. It can be attributed to simple logic. You see, penny stocks are amongst the riskiest stocks out there. And you have to convince investors really hard to put money into them. Thus, when the broader, larger indices are trading cheap on a historical basis, investors would want to invest in these stocks than penny stocks. And this is what happened for the most part of 2009. People bought into large and mid caps and slowly exhausted all the worthwhile investment options available here. Thus, it is only when these stocks start looking expensive do people start casting their net far and wide. Enter penny stocks.

Now, we are not saying that each and every penny stock is a bad investment. Infact, if the stock selection turns out right, there cannot be a better way to multiply one's wealth than a penny stock. But such odds are extremely low. It does need a very close look at the operations and a specialised form of knowledge to unearth a good penny stock. And such expertise may be out of reach of most small investors.

Secondly, buoyant market sentiment is a happy hunting ground for operators and promoters of shady penny stock companies. They thrive in such an environment. Their modus operandi is simple. They first corner huge number of shares in the underlying company and then make the prices go up by spreading false rumours about how attractive the stock is. Once gullible investors buy into the story and make the stock price climb higher, the initial investors exit with a hefty profit.

Thus, as we have seen, snakes far outnumber ladders in the universe of penny stocks and hence, the temptation of investing in them has to be resisted at all costs. After all, once you lose 80% in a stock - such losses are not uncommon in penny stocks - you will have to find a 5-bagger just to break even on your investments.


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4 Responses to "These stocks up 100%. Be cautious not happy!"

Aravind

Sep 17, 2010

Good stuff. An eye opener for someone who invest in faulty stocks.

Like 

Ketan

Sep 16, 2010

Interesting, Informative. Now one can understand what is difference between Trading and Gambling. What is solution to avoid this problem of Gambling? What is the role for SEBI?

Like 

rk77

Sep 13, 2010

Interesting article, but you have omitted the specifics - should have given some examples of penny stocks that have risen sharply without fundamental reasons and thus, pose a higher risk to the gullible investors.

Like 

anita

Sep 12, 2010

this article is a good guide for new investors and it also tells how stock prices go up &down

Like 
  
Equitymaster requests your view! Post a comment on "These stocks up 100%. Be cautious not happy!". Click here!

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