How to Find the Best Penny Stocks to Buy Today

Penny stocks are favourites of retail investors in the Indian stock market. These stocks hold the promise of providing multibagger gains within a matter of months.

But at the same time, they are the riskiest type of stocks. There is no doubt about that. They can crash anytime and for any reason. They are infamous for wiping out 90% of investors wealth in a few months.

Even worse is their low liquidity in most cases. With only a limited number of shares being traded on any given day, a small increase in volume can move the stock in a big way.

This is great if the stock moves up but it's disastrous in the case of a decline. Most investors won't be able to sell at a decent price.

Despite the risks, penny stocks are almost always popular. The only time when they're shunned is during bear markets.

In our previous editorial about penny stocks, we wrote about the kind of penny stocks to avoid in the stock market today.

In this editorial, we will do the opposite. We will discuss how to go about finding the best penny stocks to buy in the stock market today.

Let's begin...

What are Penny Stocks?

Penny stocks are shares of listed companies with very low market capitalisation. These stocks usually have low share prices, typically less than Rs 100 and often less than Rs 50.

In the US market, these stocks trade for less than a dollar i.e., for pennies. Hence the name.

In general, these stocks have the worst liquidity in the stock market. The daily average volume of shares traded is very low. It's common to see less than a thousand shares of a penny stock traded in a day.

Potential Gains in Penny Stocks

If you have chosen fundamentally strong penny stocks then you can reasonably expect these stocks to potential deliver multibagger profits.

Multibagger penny stocks are famous for greater than 1,000% gains within 1-3 years. This is almost impossible in the case of any other stock category.

This is the main reason for their popularity. Investors are aware of these potential gains and are constantly on the lookout for penny stocks that could be such contenders.

Risks in Penny Stocks

There is no good without the bad. In the stock market, you can't get high returns without taking at least some risk.

In the case of penny stocks, the risks are high. It's common to see penny stocks plunge 80-90% when the market enters a serious downtrend. This is why investors should be extremely alert and cautious with penny stocks.

There are stock specific risks to worry about too. These are stocks of very small companies. Often their business models are not stable. Many are not profitable. Corporate governance standards could be lax. Instances of financial malpractices are common.

Then there are concerns regarding the business itself even if things like growth, profitability, and corporate governance are fine. For example, high debt could be the undoing of these companies. Cash flows from core operations might be insufficient to fund operations.

Often these issues don't come to light when times are good. But when the economy/sector turns down, these problems suddenly seem insurmountable. It's no wonder why these stocks fall so much in these situations.

The market behaviour of retail investors make it worse. Retail investors commonly believe they can make a fortune in penny stocks. So they invest most of their funds into one or just a few penny stocks.

The result is usually a disaster. There is no shortage of horror stories in the stock market of people losing their life savings in penny stocks.

And that brings us to the most important point about penny stocks...

Most Penny Stocks are Not Worth Investing in

Here's what we wrote about these stocks in our previous editorial.

• A simple reality of the stock market is that you're risking the safety of your hard-earned money if you invest in bad penny stocks.
  
  Would you invest in a large-cap stock if the company had a history of making losses or a bad corporate governance? No, right?
  
  Use the same logic with penny stocks too.
  
  Just because these stocks can go up a lot is not a good enough reason to buy them. The risk-reward equation is not in your favour. If these stocks crash, your capital will be at risk. Even worse, penny stocks, unlike bluechips, often don't recover after the crash.
  
  We've already seen this happen in the Indian stock market many times with innumerable penny stocks.
  
  First time investors realise that penny stocks are not great investments when the market turns down. In fact, they realise these stocks are more likely to be wealth destroyers than wealth creators.

Don't be like these investors. Stay away from bad penny stocks. Read - Penny Stocks to Avoid in the Stock Market Today - to find out how.

This brings us to the crux of this article...

Only the top 1% of Penny Stocks are Worth Your Money

That's right. The only penny stocks worth your time and money are the best 1%.

They are the only ones that will likely not crash 80-90% in a bear market. They are also most likely to rise 10x or more in a bull market.

So how do you go about finding the best 1% of penny stocks in the market?

Before you find the top 1%, you will first need to filter out the bottom 99%.

Here's how...

Filtering Penny Stocks the Right Way

• 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 a debt to equity ratio higher 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. A good thumb rule is to reject all penny stocks in which the promoter has less than 30% stake. Also, pledging of shares by the promoters 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. These are the huge 50 and 100 baggers you hear about which have changed people's lives.
  
  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 income.
  
  By this we mean it must be profitable. Many penny stocks have exciting stories about their future driving them. But are they profitable? If the promised profits are all in the future and the company is 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 year or two, assuming there's no bear market in between. This is because the market usually needs one or two 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 six 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.

All right then. Now we have filtered out the bottom 99% of penny stocks. We are left with the top 1%.

Of course, you can't buy all of them. You should carefully select the best among the best.

Here's how to go about it...

Your Evergreen Checklist to Find the Best Penny Stocks

• Strong balance sheet: Look for low debt, high cash balances, and a current ratio greater than one, i.e., current assets should be greater than current liabilities. Equitymaster's stock screener can help you find debt free penny stocks and cash rich penny stocks.
• High promoter holding: The higher the better. It shows the promoter has skin in the game. Promoters buying shares from the market is a good sign. Use Equitymaster's stock screener to find stocks where promoters are increasing stake.
• Quality of the business: Ask the following questions. Is it a good business? Are the fundamentals strong? Will it be around after a few years? Is it making profits? Use Equitymaster's stock screener to find profit making penny stocks.
• Cash flows: Does the business generate cash from its operations? Has this cash flow grown over the years? How is the cash being used?
• Cheap valuations: It's always a good idea to buy penny stocks when they are cheap. Check if the stock is trading below its book value. A margin of safety of at least 20% below book value is a good entry point.

Conclusion

Penny stocks can be very profitable as long as you find the best ones.

These stocks are famous for multiplying 50-100 times or more and completely changing the lives of investors who were disciplined enough to hold on to them.

Investing in penny stocks is not rocket science but it requires you to practice extreme caution. On the other hand, if done correctly, picking the right penny stocks will significantly boost your portfolio's returns, especially in the long term.

Finally, we suggest watching this video by Rahul Shah, Equitymaster's co-head of research, about investing in penny stocks.

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...