How to buy penny stocks in the stock market? Is there a good methodology or steps that you can suggest to buy into penny stocks in the Indian market?

What exactly do we understand by penny stocks? There is no standard definition for penny stocks. For example, in the US, stocks quoting below $1 are referred to as penny stocks and that is how the name catches on. In India, normally stocks quoting below the general par value of Rs.10 are seen as penny stocks. Some even broaden the definition to include stocks that have sustained at lower levels for a long time and ignore the temporary falls in stock prices. Then others use Rs.20 as a cut off limit while others ruse an 80% correction in the stock price as a definition of a penny stock. In such cases, it is indicative of a stock that is gradually moving towards penny stock status over a period of time and is seen as an astute warning of a stock that needs to be avoided at all costs.

Penny stocks can have strongly negative implications at times. In the past, we have seen penny stocks correcting sharply and underperforming the markets as a whole. These penny stocks are known to outperform the market in a market uptrend but they grossly underperform in a market downtrend. So, what exactly is a penny stock? While there is no standard definition, penny stocks are normally stocks that are trading close to their par values. In the Indian context, the normal par value of stocks is Rs.10/share. Of course, with subsequent stock splits, this par value tends to change. In the Indian context, penny stocks are those stocks that quoting at a price of less than Rs.20.

It has been seen that penny stocks have given supernormal returns over extended periods of time. Take the case of Indo Count, which was a penny stock till about 6 years ago. From being a single digit stock, the stock moved all the way to Rs.1100/- before the stock split happened. Similarly, a stock like Indiabulls Ventures has appreciated from Rs.16 in November 2016 to Rs.290 in September 2017. That is the kind of returns you just cannot imagine in large cap stocks. Here are 5 ground rules for you to go and buy penny stocks in the market…

Don’t bet your bottom dollar on penny stocks

That is the cardinal rule. You cannot get overexposed to penny stocks. That means; you cannot allocate 70% of your equity exposure to penny stocks. You are running a huge risk then. Ideally, around 10-15% of your equity portfolio can be allocated to penny stocks. Even if you find penny stocks outperforming, you need to have the discipline not to overshoot this range. Consumed in small quantities, penny stocks can go a long way in creating alpha in your portfolio. But, it is dangerous to have your entire portfolio dependent on the performance of penny stocks. Remember, penny stocks always tend to be under the watchful eyes of the regulator, as we have seen in the past.

Buy and hold does not work in case of penny stocks

The likes of Warren Buffet and Peter Lynch may be working in case of diversified portfolios; but that is unlikely to work in case of penny stocks. Remember, penny stocks need to be closely monitored for news and events and your portfolio must be flexible enough to make changes where required. Most of these penny stocks are yet to prove themselves and hence a very long term perspective is not advisable. You can look at frequent entry and exit. That could mean a slightly higher transaction cost, but that is still better than buying and forgetting about your penny stocks.

Do your homework before entering a penny stock

This may sound a hackneyed sort of advice but it is extremely critical in case of penny stocks. It is quite normal for investors to buy penny stocks just because some large high-profile investor has been buying the same. That can be a dangerous strategy as you do not know the reason the stock is being bought. Also the large investor’s risk appetite will be much bigger than yours and so will be his capacity to take losses. There are also cases when large investors team up with certain dubious promoters to push the stock price up. If you follow the lead of marquee investors, you may end up being the sucker in the trade. Understand the company; if required travel down to their plant / office and do your own research. Talk to other brokers, clients and suppliers in the market. Normally, a four-dimensional view is rarely wrong. The moral of the story is that you need to do extensive homework before buying penny stocks. Avoid tips and more importantly, avoid the bandwagon mentality.

Track the market structure of the stock

A lot of focused market data can be easy a give-away about whether the stock is genuine or not. Check if you can see patterns of circular trading in the stock. Try to see if the same names are appearing in the daily Bulk Deals list. Are you seeing sudden shifts in buy/sell volume patterns? These are all indications that the stock price is being managed. It is best to keep off such stocks. Look at the A/D ratio of the stock and the delivery ratio over a longer period of time. They give you credible cues about the quality of the penny stock. This market structure can be relied upon as a good indicator of the underlying strength of the stock. Above all, check the liquidity consistency and the impact cost of the stock. That will give you an indication of the ease of exit in an emergency.

Time your purchase of penny stock to perfection

If you really want to make money on penny stocks, you need to be able to time your purchases properly. Don’t try to buy penny stocks when the macroeconomic parameters are underperforming. These penny stocks could be the worst hit. Secondly, avoid the temptation to average your penny stock holdings. You have to take call to either continue with the stock or exit the stock altogether. This is not a stock where you can be assured that the mean reversion will work in its favour. That does not work with penny stocks. Lastly, never try deep value investing in penny stocks. Penny stocks work best when momentum is favourable. The minute you see market momentum vanishing, the first to go out of your portfolio should be penny stocks.

You don’t need to shun penny stocks altogether. Of course, if you are a conservative investor or if you are a first time investor then it is better not to risk your bottom dollar on these kinds of stocks. These penny stocks are by default speculative and you must only get into them if you are conscious of the risk involved and willing to take it on. It is a fact that penny stocks are risky, but it also true that penny stocks can give supernormal returns. The best way is to start off with a small allocation to penny stocks. That could be a good starting point!