Why do I avoid Penny stocks?
Being an Equity analyst, I regularly face many interesting questions while dealing with my clients. Some are very common like –“Why do you advice the companies whose share price are already high enough? Why don’t you suggest me some penny stocks?” My answer is always “Sorry, I can’t”.
Yes, I never advice to buy any penny stocks for long term holding purpose. There are may be thousands of news everyday showing several penny stocks have gained 1000% or more in last 1 or 2 years or so. But I generally stay away from those stocks and also advised so. Today in this article I’ll explain why I do so.
Before starting, I would like to explain the term “penny stocks” for the newbies. The penny stocks are the stocks whose price is less than 5 dollars or so. Normally these are the equity shares of the small public companies and are thinly traded.
Reasons of avoidance
1. Can easily be manipulated:
As I was discussing the penny stocks normally are thinly traded. Promoters or manipulators targeted those stocks and they heavily bought those stocks at their own account at low price. Then artificially inflate the share price through some misleading positive statements. These promoters or manipulators may be associated with several institutions also and these institutions advice their clients buy these shares as inside news or may be fake press releases.
The investors also observe that price is rising as the buying pressure is rising. When there is a general belief in the market that this share is very good and everyday it breaks it targets and make a new target, then the promoters or manipulators sell off their holding and share price fell down heavily. The general investors get trapped in these shares.
2.Difficult to sell for less of liquidity:
As I was discussing, these types of stocks belong to small companies and are thinly traded. These shares get huge volume only during the midway of the time window when manipulators inflate the share price. But before and after that the volume decreases dangerously and it becomes almost impossible to sell off the position as no new buyers come to buy this companies shares because of negative news.
3. You may lose all your money:
Since the penny stock companies have low asset value, there is risk that these companies may go bankrupt. A long term investor who has bought this share with a buy and hold strategy, may have worthless stocks after a certain time. Because within some months, the stocks will be delisted and the investor will lose all his money.
Even if you have no plan to hold the penny stock for a long time, you might have bought those shares when those are “hot” and may not be able to share at higher prices and you may be running in loss.
4.No Dividend payout history:
As these companies are small , these companies generally don’t have a steady dividend payout ratio. As advisors we normally prefer the companies for long term holding which have steady profit growth and consistent dividend payout history. In this aspect also, it makes no sense to hold on to these shares.
5.Other Parameters of Fundamental analysis:
Normally the shares for long term holding are chosen based on Fundamental analysis. Like- industry analysis and company analysis. Company analysis comprises of revenue analysis, operating profit analysis, future growth plan, management ability, etc. If you observe in all these aspects of most of the penny stocks, you’ll get fishy report like the report will differ from one institution report to another. Because, manipulators publish the artificial report and they manipulates those time to time. So it is better to download the annual report from the company website and check the information carefully before investing in such a company.
It’s your money. Don’t buy on hype or sell on panic. Long term investment in equity is safe but only on blue chip companies. Invest carefully.