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 )
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 )
posted by Dr. Tejinder Singh Rawal at 11:12 pm
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