Penny stocks are a big attraction for investors. You don’t need much money to get started unlike other forms of investing. But penny stocks are comparatively tricky in terms of earning profits. Investors tend to fall into value traps as penny stocks trade at a lower price.
But, there have been success stories of penny stocks that became multi-baggers over time given their strong fundamentals. In this blog, you will learn how to select the winning penny stocks.
What Is a Penny Stock?
A penny stock is a stock that trades at a very low price. For example, a stock with a value less than Rs. 10 can be called a penny stock. It belongs to a company having a low market capitalization with a limited amount of information available to the public.
As the trading volumes in penny stocks are low, they have a large bid-ask spread and they carry a big risk. These types of stocks lack liquidity. Also, they have the potential to offer higher returns as the company has a good potential for growth.
Let’s learn how to select the winning penny stocks in India:
- Decide if Penny Stock Is a Good Option for You
Decide if you are comfortable with the high risks that come with penny stocks. If you don’t want to take any risk then it is best to avoid investing in this stock.
- Learn About the Market
Penny stocks investment requires a good understanding of the share market. Factors like natural calamities, war, elections, modification in government policies, new technology, etc. drive stock prices. As penny stocks are not fundamentally strong, they react to all these events. Hence, good investors are better at selecting penny stocks than beginners.
As the price of penny stocks is low, many individuals or companies may manipulate the demand for these stocks by buying them in bulk. Once the price increases due to high demand, they sell these stocks in bulk causing the price to drop. Therefore, make sure you understand the share market before you put your hard-earned money into it.
- Do Your Research
The stock market consists of the majority of small-caps and lower stocks. Therefore, there are plenty of options to select penny stocks. Start your research by creating a broad set of criteria that will help you identify the sector, industry, etc., and make a primary list of stocks that you wish to consider. Further, keep modifying the criteria as per your requirements to get to the final list.
For example, you can invest in the eCommerce sector since your findings tell you that online shopping is the future and there are many good start-ups with growth potential. Then you can start shortlisting the names and then pick the ones that show the potential of turning into a multi-bagger. With time and enough experience, you can create filters based on macroeconomic events as well.
- Practice With Paper Trading
Paper trading includes creating a hypothetical portfolio of stocks and then trading them as if you would trade in the real market. There is no real money involved here. This helps you test your knowledge of the workings of the share market and make the right decisions.
Create an excel sheet of penny stocks that you would buy today if you were to trade in the market. Also, create a watchlist of penny stocks. Track them and make an entry on the sheet when you decide to sell. Do this for 2-3 months to analyze how your hypothetical portfolio is performing. This will help you choose the best stocks.
- Watch Out for Constant Dilution
A company gives out shares to raise capital. Generally, this capital is needed for growth and expansion. But smaller companies may require additional capital or issue employee stock options to get better talent. This may result in dilution of the ownership percentage of the existing investors.
Therefore, if a company is constantly issuing new shares, the value of the shares held by the company will go down. You should avoid companies that have a history of continuously changing their share structure.
- Don’t Speculate
Not all penny stocks have low market capitalization. Market-Cap gives an idea about the worth of the company in the market but it is not an indicator of how the company might perform in the future. Therefore, you must assess the fundamentals of the company before investing your money into it.
Understand the business structure of the company and assess if it can give profits based on its operation. Check out its competition, free cash flow management, the efficiency of the management team, financial records, and other fundamental factors to identify if the company can perform well in the future and experience high demand.
Keep in mind that the stock prices can be low for several reasons. Therefore, it is wise to avoid investing in a stock if you don’t know the reason for its low price. You may feel tempted to speculate but avoid it.
- Be Careful of the Gold Rush Approach
Most of the investors are attracted to the penny stocks as they are cheap and expect their thousand rupees to turn into lakhs. There have been cases of penny stocks that turned multibaggers but it is very rare to find.
In the golden rush approach, the investors tend to invest in a penny stock when they hear that it is offering 5X to 10X returns and this leads to a rise in the stock price. The investors fail to analyze that if the company has weak fundamentals, then the price of the stock will fall eventually. The gold-rush approach has led to huge losses for investors in the past.
There is infinite information on the web that will lead you to many such gold-rush stocks that claim to hit a jackpot. Do your research and bet on the company fundamentals and not the stock price.
- Know Your Investment Horizon
Keep in mind that penny stocks are not meant for intraday trading or short-term positions. Stock prices are governed by the supply and demand in the market which is based on the perception of the company among the public. Changing the investor perception takes time even if the company is performing well. Therefore, you should look at a medium to long-term investment horizon.
- Monitor Your Investment Regularly
Penny stocks are a good way to understand how the markets respond to the performance of a company. Therefore, you should monitor your penny stocks regularly. This will help you to understand the trading patterns and make better investment decisions in the future.
Now you know how to select the winning penny stocks. Penny stock may seem to offer promising returns, but they come with high risk. Therefore, you must ensure that you conduct thorough research before investing in penny stocks.