Penny Stocks

Penny Stocks: You Get What You Pay For
Dr. Tejinder Singh Rawal
tsrawal@gmail.com

Circa 1995: Soundcraft Industries , a “multicrore” turnover company engaged in “diamond trading” business unveils a massive expansion plan. The Press Release, issued by the company, and widely circulated in media, says, “Soundcraft Industries, which is engaged in exports and trading of diamonds, precious stones, granites and garments, is planning a major diversification into waste-to-energy projects. The company hopes to invest Rs 1,700 crore in these projects where it would manage solid waste of 8,000-10,000 tpd.” Most investors notice the company for the first time. The Press Release is followed by a series of Press Releases and advertisements claiming that the company is embarking upon the state-of-the-art technology which would revolutionise the solid waste management in the country, and is in the process of tying up with major Municipal Corporations. You get a ‘tip’ from an ‘insider’ and you decide to invest. The share price rises exponentially, and is unstoppable, you buy more shares, and price rises further. Total appreciation is a whopping 600%, then one day the company vanishes into thin air. To your shock, you discover the fact was that peons, drivers and clerks were the directors of the company, and the registered office of the company was a car garage. By the time you discover that you have been cheated, Rs.50 crores of investors’ wealth has gone into thin air. The promoter of the company Raj Basantani is absconding.
Circa 2004: Company: Kolar Biotech Promoters: Same Investors: Same Strategy: Same Investors burn their fingers again and this time it is Rs. 200 crores that has gone down the drain. Raj Basantani is absconding again. Those who do not understand history are condemned to repeat it.

With market touching the 12K mark, too much “irrational exuberance” prevails in the market. As the market gets overheated valuations get stretched up. While the momentum drives the quality stocks to dizzy heights, stocks with dubious track records are also not left behind. In September 2005 SEBI intensified market surveillance and analysed about 1000 penny stocks for unusual movement in share prices during a short span of time. Some of the companies, like Eltrol Lltd, Database Finance Ltd, G Tech Infotraining Ltd, Shukun Constructions Ltd, Island Industries, TSL Ltd, Rashel Argo Ltd Betala Global Ltd, Mantra Online, Bottom Properties had risen by 500% to 6000% in a few months’ time. Most of these companies had no track records, they were operating from fake office addresses, but were witnessing huge trading volumes. As a result of the probe the prices of such shares went down faster than they had gone up, before the poor investor could get an opportunity of it. They would never rise again. The promoters would jettison the companies and shall come back in a new avatar.

With so many quality stocks available, it surprises me why investors should ever think of getting into something that is akin to playing a lottery. Most of these stocks are danger pure and simple. The highest that one can pay, based on the valuation of such shares, is usually ZERO. 90% of penny stocks are junk. While you may beat the market by identifying some good scripts out of the remaining 10%, it is not worth the effort. Some people get into penny stocks on the logic that the stake is small so the loss could be equally small. What the investors don’t realise is that while per share price of a penny stock may be low, the total quantum of loss may be substantial: You will lose 100% of your capital invested in penny stocks.
Manipulation of penny stocks is a huge problem that shows no signs of letting up. Unscrupulous brokers shamelessly "pump" small-cap stocks, using their informal channels to spread the “inside information”. They come by phone, through e-mail spam, or through a friendly sub-broker. In many cases, a carefully crafted and fostered ' rumour mill' alerts you to a penny stock through a friend who knows a friend of a director.... As the “inside information” gets some footing, they start issuing press releases about the spectacular growth of the company.
The financial fraud known as “pump and dump” is the usual strategy that manipulative promoters adopt. It involves artificially inflating the price of a penny stock in order to sell at the inflated price. Unwitting investors purchase the stock in droves, creating high demand and pumping up the price. If you are lucky, you will pass on the stocks to a ‘greater fool’, the greater fool may offload it to a ‘still greater fool’. Very soon the ultimate fool will be found out, the man who will be holding the shares at high price for which there is no buyer. And while you all were indulging in passing the parcel the smart promoter was dumping his shares, and was getting ready for a trip to Geneva to invest the booty.
Penny stocks are very thinly traded and are valued at their penny levels for a reason.....they aren't worth much. In Indian context I would consider shares trading at less than par value to be penny stocks ( Less than Rs. 10 shares) . I would also include in the definition shares of companies having meager market capitalisation of, say, less than 10 crores, which are easy to manipulate.

Avoid “Z” category and T2T stocks. With a view to forewarn investors planning to make an investment in the securities of the companies, which have violated provisions of the Listing Agreement or have large investors complaints pending against them, BSE shifts all such securities to a separate category called "Z" group. At times, the trading and settlement in scripts is placed by the Exchange on Trade to Trade (T2T) basis because of Surveillance reasons. Stay away from them. They lack liquidity.

If the company doesn't have revenues, look no further. Don’t go by the promising future. How can a company which is operating from a garage have wherewithal to invest Rs. 1200 crores in a new bio-tech venture? Make sure that the company has been generating revenues for a few years, and is not a fly-by-night operator who has window-dressed a balance sheet and passing it off as an attractive investment. Essentially, when evaluating small companies for investment, the ability to generate cash is important. I would rather play it safe when it comes to such companies, and I strictly follow the ‘margin of safety’ principle here. If you are getting something at a discount to its asset value, then only it can be considered. Take future promise with a grain of salt, buy the present value.

Never buy shares whose liquidity is low. If the trading volume is low it makes it very easy for other traders and market makers to manipulate the stock as they see fit and believe this, it will not be in your interest when they do this. This is the chief reason I advice you to avoid companies with low market capitalisation.

Never invest in a company without first reading its financial statements. Thanks to Internet, such information is easily accessible. SEBI’s website http://sebiedifar.nic.in/ is a great repository of the financial statements of companies. A visit to SEBI’s website, before you decide to invest is a must. Investment does require hard work, but it is worth the efforts.

Finally, not all penny stocks are bad. Most successful companies start as penny stocks and work their way up to success. However, you should be sceptical of “the future Infosys” and “the future TCS”. While one of the companies may become an Infosys in future, there will be a hundred which would get wounded in their journey. You would be making the error of what is called the “survivorship bias”, if you start looking at every small-cap as a future Infosys.

If the baker comes to you with hot cross buns, one a penny, two a penny, hot cross buns, grab them. They are too tempting to resist. If you have no daughters give them to your sons, but please, for God’s sake, don’t buy one a penny two a penny stocks, however strong the source of your information may be.

(The author is an eminent Chartered Accountant. He invites comments at tsrawal@gmail.com )

A fool and his money

A fool and his money will soon be invited everywhere: The folly of market timing
Dr. Tejinder Singh Rawal
tsrawal@tsrawal.com

There is a way to make a lot of money in the market; unfortunately it is the same way to lose a lot of money in the market.
Peter Passell and Leonard Rose
The share market continues to surprise all. In recent past it has surprised even the most optimistic bull operators by giving a better than expected return. Invariably every person I come across asks a question, "What's the market going to do next? How high (or low) will it go?". I feel this question is not relevant. The relevant question ought to be: “What does my long term investment strategy call for in present market conditions?”
It is every investor’s dream to get in the market when the market is low and sell when it is high. People employ all kind of strategies to find where the market would be tomorrow or the next month. A successful market timer does not have to do much homework since market timing alone delivers handsome returns for him, which makes him confident of his own strategy. This payoff to timing the market makes him an easy victim for the next market-timing strategy.

Market timers have a wide range of tools available at their disposal. Some of them are apparently spurious; others may give an impression of an exact science. Some people consider macroeconomic variables – like interest rates and GDP growth- to predict that you must buy shares when interest rates are low. While low interest does lead to higher economic growth, it may fail to lead to higher share prices if the growth was less than what was anticipated by the market. Some people would use the feel good indicators (opinion of the experts on CNBC, speech of the Finance Minister, and RBI Governor), while some rely on the opinion of cocktail party chatters! I even came across an economic model built trying to predict the stock market direction on the basis of the prevailing trend in the hemline of women’s skirts!( Believe me, there is a theory called Hemline Effect Theory to be found in Financial management). The argument is that, rising hemline denotes boldness and fashion consciousness which comes from confidence that you get from a buoyant economy, and is an indicator of a stronger market, while increasing length of the skirts denotes a conservative and cautious approach!

Market timing refers to an attempt to time investing decisions so as to invest in assets which are expected to go up in the near term and divest from assets which are expected to go down in the near term. The simplest implementation may be to shift one's assets between cash and stocks generically in order to take advantage of anticipated stock market movements. Market timers are the ultimate “buy low and sell high” traders. Day traders, who move in and out of positions in minutes or hours, are the extreme market timers. They look for small profits each day by capitalising on swings in a stock’s price.

I strongly advice against market timing in its various forms. Many a time when you try to time the market you end up doing a reverse timing, and you end up buying when you should be selling, and selling when you should be buying. It is `time in' the market and not `timing' the market that is important. The long-term stock investor prospers because he owns shares in businesses that are a part of one of the fastest growing economies in the world. The important thing is not so much when you buy, but that you buy and continue to buy and hold.

A great strategy in a volatile market could be what is called a rupee-cost averaging. The strategy is to invest a fixed sum of money periodically, say every month, over a long period of time in fundamentally strong shares. This evens out fluctuations arising out of short term ‘noise’ and long term trade cycles. To start with you may identify a basket of , say, 10 scripts. You keep investing a fixed amount in this basket, for a period of five years. An example will clarify the approach. Suppose you invest Rs. 2000 every month in Reliance Industries (RIL) shares over a period of 5 years. When the price of RIL was Rs. 500, you bought 4 shares, when the price fell down to Rs. 400 you bought 5 shares, when it shot up to 800, you could buy only 2 shares ( and utilise balance Rs. 400 in buying another share from your basket) . If next month should the price fall to 600, you would automatically up your investment in the company. The obvious advantage of this strategy is that you are automatically buying more shares when the market falls and fewer shares when the market rises. This automated strategy could be more suitable for the investors who do not have the time or the expertise in identifying value buys. The strategy, these days popularly called Systematic Investment Plan (SIP) could also be utilised by passive investors for buying Mutual Funds over a period of time.

Economist William F. Sharpe, wrote in an article, "Likely Gains from Market Timing," in Financial Analysts Journal "... unless a manager can predict whether the market will be good or bad each year with considerable accuracy, (e.g., be right at least seven times out of ten), he probably should avoid attempts to time the market altogether." If a Noble laureate like Sharpe could not make money by timing the market, since he knows that he cannot be right at least seven times out of ten, needless to say, market timing is a strategy to be avoided by investors.

"The long, sad history of market timing is clear: Virtually nobody gets it right even half the time. And the cost of getting it wrong wipes out the occasional gain of getting it right. So the average investor's experience with market timing is costly. Remember, every time you decide to get out of the market (or get in), the investors you buy from and sell to are the best of the big professionals. (Of course, they're not always right, but how confident are you that you will be 'more right' more often than they will be?) …Charles Ellis, Winning the Loser's Game. What is more, every time you get out of or in a share, you may brokerage, and also pay short term capital gains tax of 10% on the profits booked.

Looking back at market history, there have been far fewer successful market timers than successful stock selectors, and it is not clear whether even the few successes that can be attributed to market timing are more attributable to luck. Why is it so difficult to succeed at market timing? First, it is not possible to predict the future. Market is the sum total of the behaviour of the individual players. While at times market may behave rationally, more often that not it does not do so. It is the rational behaviour that alone can be the base for the science of prediction. Fitting something that does not behave rationally to a scientific straightkacket can lead to disastrous consequences. A far better solution is: not to be bothered about the direction of the market, but to approach the investment using a bottom-up approach. Identify a fundamentally strong script, which is trading at a price lower than its value, thereby giving you a comfortable margin of safety, and invest in such stock. You are likely to come across such stocks in all market conditions, bullish as well bearish. And if you don’t find any such investment, it would be a prudent decision to sit on cash, rather than invest. Warren Buffett’s investment vehicle, Berkshire Hathaway is known to be sitting on a large pool of cash when it cannot find safe investment opportunities.
Put the watch down, and relax, you can't time the market. Invest whenever you are ready. A wise investor is patient, disciplined, and focused on long-term goals.

(The author is an eminent Chartered Accountant. He invites comments at tsrawal@gmail.com )

Liberty. Fraternity. Equity.

Liberty. Fraternity. Equity.

Fundoo Professor: Reflections on Indian Stock Market Levels Revisited

Fundoo Professor: Reflections on Indian Stock Market Levels Revisited