How to Invest and Make Money with Penny Stocks

The euphoria surrounding penny stocks among rookie, retail investors in India is crazy.

Indian investors usually are attracted to penny stocks as their stock prices are low and can be bought in huge quantities.

But that's a problem, because penny stocks are highly volatile and risky asset class that have left many investors in vain over the years.

However, there are some instances of penny stocks that are known for generating multi-bagger returns as well.

If you are planning to invest in penny stocks, don't worry, we've got you covered.

To help you out with this, we reached out to our penny stocks guru Rahul Shah, for his guidance on penny stocks investing.

This interview is a must read if you are serious about making money from penny stocks...

Equitymaster - Congratulations on the stupendous track record that you have built up with microcaps over the last 7 years. What's the secret to beating the BSE Sensex by a margin of 2 times?

Rahul - Thank you so much. It reaffirms my faith in the philosophy that in order to become a successful investor, one doesn't need superior intelligence, unusual business insights or inside information.

All that one needs is a sound blueprint for making decisions and the ability to keep emotions from damaging this blueprint.

Equitymaster - Another area where you have been a trail blazer has been penny stocks. What do you think about the skepticism over penny stocks investing in the Indian equity markets?

Rahul - I think the skepticism is justified to a certain extent.

As a group, penny stocks may have certainly destroyed a lot more shareholder wealth than any other group out there.

But the reverse is also true.

If you get into the right penny stocks at the right time, the upside potential could be tremendous.

Thus, it all boils down to separating the penny stock men from the boys. We need to have a process to zero in on only those penny stocks where the upside to downside potential is in favor of the investors.

Equitymaster - Now over the years you have shown how to make money with penny stocks. A lot of it! Could you share a few tips on how one can go about selecting the right penny stocks?

Rahulpenny stocks that are investment worthy and the ones that are highly speculative. We have developed an in-house system which has been able to do this with a very good success rate.

We refer to this as the SOLID framework for penny stock investing. Here S stands for strong balance sheet, O for Owner Operators, L for long term business viability, I for Income generating and D for deeply discounted valuations.

In short, we do not recommend a penny stock that does not qualify on all the above parameters. It is strict adherence to this system that has allowed our subscribers to make good money from penny stocks over the years.

Equitymaster - As someone who has studied market cycles over decades, how do you read the situation today? How should investors factor this in when making investment decisions.

Rahul - Investors need to understand that penny stocks go up the most in a bull market and also fall the most in a bear market Thus, the right time to invest in them is at the start of the bull market and the worst time is when it is close to its all-time highs.

Most investors end up doing the opposite and this is the number one reason why investors get disillusioned with penny stocks.

In my view, right now is not the time to take maximum exposure to penny stocks as the market has already gone up more than 100% from its lows.

Equitymaster - If you were sitting on cash today, had the risk appetite, and a tenure of 3 years, how would you allocate money? Also, what role would penny stocks play in this? Let's take Rs 100 in cash...

Rahul - As I mentioned in the previous reply, the market has already gone up more than 2x from its lows. Therefore, this is not the time to take maximum exposure to penny stocks.

If I had Rs 100 today and if I was investing in penny stocks from a 2-3 year perspective, I will maybe take only 50% exposure to penny stocks or even as low as 25% and keep the remaining in bonds or FDs.

Thus, in the future when the markets correct, I can take the exposure to as high as 75% of the overall corpus dedicated to penny stocks.

This, in my view, is one of the best ways to maximise profits and minimise losses from a space as volatile as penny stocks.

Equitymaster - You are always on point when you quote the investing greats like Benjamin Graham. Anything you want to share with us today...

Rahul - Graham once mentioned that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

A lot of poor quality penny stocks can have one or two years where they earn good profits.

Investors should not confuse this prosperity with safety and end up buying the stocks.

They should always stick with stocks that have at least a 5-year track record of stable or growing profits or both and also a strong balance sheet. Otherwise, the risk of losing money in the penny stock space is very high