In their quest to make quick bucks, most investors are always in the hunt for the next multibagger, a stock that will multiply several times over a couple of years. They believe the best place to look is among small stocks, or penny stocks — usually stocks that are trading at below . 10.
But the universe of penny stocks can be quite tricky, especially at a time when the markets are volatile and where investors can't find safety even in blue chips. Over the past month, the Sensex has lost 6%, with many large caps, like State Bank of India and Reliance Industries, taking a heavy knock.
As the market turns choppy, investors get into value-hunting mode and some look at smaller companies in search of higher returns than the market's.
SMALL AND ATTRACTIVE
Though the space has the possibility of offering the next Reliance, HDFC or Infosys – wealth creators, in other word – there are inherent risks. But first let us understand the opportunity. There are two segments of stocks that attract investor interest. The first category is the eternally popular penny stocks. Some define them as stocks quoting below . 50. The charm here is the absolute low price of the stock. Retail investors find it easy on their pockets to buy a substantial quantity in these scrips.
The second category of stocks is small-cap stocks — those with low market capitalisation. The market capitalisation of a company is arrived at by multiplying the current market price of the stock with the number of outstanding shares. In the Indian context, generally, stocks with less than . 2,000 crore market capitalisation are treated to be smallcaps. Stocks with less than 1,000 crore are treated as micro-caps. Investors expect high growth in business and profits of such companies over a long period of time. But does that warrant investment in every small and penny stock?
CHECKPOINTS
The people behind a business are an important consideration. Quality of the management is the most important element one should watch out for. The management should be able to execute the growth plans of the company as per the schedule. It is important that the management is high on integrity and has a mindset to share wealth created in the business with the minority shareholders.
While assessing the opportunity, you have to be rational. Investors prefer to rationalise their actions rather than act rationally, which is why most investment mistakes happen.
The flow of information about unknown names in the markets is rather inconsistent. A point to note is that analysts rarely cover penny stocks. You have to seek information from the right sources. Sometimes, shenanigans use blogs and internet groups to spread information that paints a rather rosy picture for a company. But it is always better to validate such information.
Investors should depend only on information disseminated by the company through the stock exchanges. Information about quarterly results is available on the stock exchanges. The company may also choose to conduct a conference call for investors and analysts. Here you can interact with the top management of the company. Some companies do conduct analyst meet and factory visits to communicate their future plans. Information received from such initiatives, however, must be seen in light of the macro factors.
Blindly chasing a stock based purely on some information may lead to loss of capital. You should figure out where will the growth come from. Also check what are the capital expenditure needed to realise the growth projected by the company and find out if the company has the resources in place. Then there are the macro-economic factors like the rate of growth of the economy and the sector.
You should assess the growth projections in the backdrop of the demand scenario for the products and services of a company. If the user industries are not doing well, one should better validate the growth projections.
The company should also have access to increased supply of inputs for the higher growth it targets. If the company is talking big growth plans at a time when the industry in which it operates is suffering from over capacity and almost zero growth, better find out the reasons behind such growth projections.
TRACK YOUR INVESTMENTS
The 'buy-and-forget' psyche can be detrimental if you are investing in small and penny stocks. You have to keep track of the business of the company. We prefer to interact with the management at least each quarter to understand the business performance. Be careful about negative surprises in performance. There are instances where the company does an analyst meet, discusses business, gives projections and then shuts the doors for analysts for a long period of time. Such companies sometimes may be traps for investors, because investors turn helpless as the business starts dwindling.
THE PRICE
The price is more important than most other factors. "Buy a smallcap counter that has a scalable business and a good management in distressed times as the valuations are rock bottom and the probability of going wrong is minimum," says an equity analyst with a mutual fund. Avoid buying such counters in boom phases for long term, since in most cases they are priced above the fair value.
THE RISKS
Liquidity is the key issue in this space. For small-cap counters, if the floating stock is minimum, the investor may not get to exit when the market sentiment turns bad, as there may not be a buyer. Hence, it makes sense to introduce quantitative filters while entering a stock. For example, some investors prefer to buy a quantity of shares less than or equal to the average daily volumes for the previous year. Some investors also prefer to restrict the exposure to such stocks to 5% to 10% of their portfolio.
As these companies are in the early phase of growth, they need a conducive environment to grow. Slowdown in an economy is a big risk here. Stocks of small companies capitulate faster and they take more time to recover. Large and established companies, on the other hand, can withstand the storms in the economy better.
Then there are behavioural issues that affect investors' decision-making. Many times, investors get influenced by the low price of a stock. The cheap can become cheaper. The possibility of loss for some is very low in low priced scrip. But many forget the fact that if scrip, priced at 5, delists, it may be the precursor to total loss of capital.
While investing in small-cap and penny stocks one must be hands-on. You should do thorough research to ensure that you earn good risk-adjusted returns. It pays to introduce stop-loss levels for each stock and run a diversified basket of such stocks than having your portfolio concentrated with just a few them.
