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Should you invest in penny stocks?

B S Srinivasalu Reddy | July 19, 2005 13:20 IST

Market pundits say the rally this time is built on strong fundamentals. True. But this may not be the case for every single stock.

The reality is that several penny stocks have run-up far beyond their fundamentals. And that spells trouble for common investors who often pick stocks based on momentum.

Sample this: On the basis of price-earnings (P/E) multiple, penny stocks such as Shree Steel (23 times) and Om Metals and Minerals (14 times) are costlier than the globally competitive steel company Tata Steel (5.61 times) and SAIL (3.17 times), though they are not strictly comparable based on their nature of business. Tools manufacturer, Akar Tools, has a P/E of 46 times.

There is no doubt that many a small investors have reaped benefits on their investments in small stocks during the recent protracted bullrun. But a change in the situation can prove to be disastrous.

The risk is that when the sentiment turns for the worse, penny stocks tend to depreciate giving no time to investor to even think. Lack of liquidity in small-cap stocks also means that investors may not be able to exit as easily.

"Usually, small investors who bank on low priced stocks will benefit as long as the market is on the up-trend, fuelled by good liquidity. But the situation reversal would take these stocks back to their very levels at the same pace, which could make them dorment awaiting another bull-run," says V V L N Sastry, head, Firstcall India Equity Advisors.

But why do penny stocks tend to move up so sharply? Often, operators in stock markets enter with a specific purpose of boosting certain penny stocks taking advantage of the bullish sentiment.

These operators tend to push up stock price. And when small investors notice the rising trend in a particular counter and start buying into the story, operators are ready to offload their shares pocketing substantial gains. That is why, one analyst explains, several dormant stocks also find takers during bull runs.

Adds Sastry, "Small investors usually look for stocks that match their investment capacity and pick up low-priced stocks. Such investors mostly go by word of mouth counsel of friends and relatives. Most times, such advices may not make money."

Sharmila Joshi of Asit C Mehta says, "There are many investors who have raked in money in the boom time, thus far by picking up momentum stocks. But investors need to analyse the risk associated with a stock and evaluating the prospects for the company before investing."

According to Sastry, identifying companies with strong business well poised for a turnaround in performance are ideal penny picks.

Besides, investors should prune their exposure to individual stocks as and when stock hit a certain price target.

Even if the moment is strong, it is as important or more important to book profits in penny counters as in large-cap stocks.

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Number of User Comments: 3

Sub: Penny Stocks

Investing money in penny stocks is not an Investment but more of Gambling without rock solid reason of them in ur portfolio. The chances of ...

Posted by Rakesh

Sub: Take example of CMM

This is very true , just take exaple of CMM Broadcasting. share moved from Rs.5 to Rs.15 in just a week time & now again ...

Posted by imanali

Sub: sure, why not?

listen friends, first of all, stock markets are not for the weak follows NEWTONS THIRD LAW.. "what goes up must come down" when you ...

Posted by chacko


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