When equity markets turn volatile or move in a tight range for a long period of time, it gives rise to two types of market traders—those who swear by “bluechips” and those who fish for “penny” stocks, thanks to low valuation. “Bluechip” and “penny” are commonly used terms to describe particular types of stocks found in the equity markets.
Bluechips, as we know, are premium shares that are backed by high market capitalization and quality companies. Penny stocks, on the other hand, are not so easy to define.
What are penny stocks?
As the name suggests, penny stocks trade at a low absolute price. The price may not be in paise, but it is generally accepted that penny stocks trade for a price that is no more than Rs.10-20. Another way to identify a penny stock is to check if its price is less than its face value.
It is more important to consider the fundamental attributes of such stocks and the underlying company. A penny stock has a low price and low market capitalization. It isn’t necessary that these stocks trade every day. Often they are part of the trade to trade segment. What this means is that they have very low liquidity and the difference between the bid price (buy price) and ask price (sell price) can potentially be very large. So transactions are done over the counter rather than through an exchange.
Thanks to the lack of liquidity, speculative trading in such stocks picks up and hence, these are considered risky. With regards the underlying company, usually it is a small-cap company with limited business and growth prospects. The company behind such stocks usually has little to show by way of financial health and management strength. But often these companies are in news and stocks get a boost from that.
Why is it attractive?
The sheer number of penny stocks in the market makes them hard to miss. In the Bombay Stock Exchange (BSE), there are 725 stocks trading below Rs.10 and 1,171 below Rs.20. On the National Stock Exchange, the number is 355 and 189, respectively.
The main reason for buying a penny stock is that an investor can get a large number of shares at a small total value. For example, if a company’s market price is Rs.9, you can buy 1,000 shares for just Rs.9,000. On the other hand, if you were to pick a bluechip company with a current market price of, say, Rs.1,800, you would only get five shares. The hope is that the penny stock will give superior returns as the stock price is low; with 1,000 shares, you can benefit a lot.
In reality, stocks that are backed by companies with good fundamentals, financial health and strong management are the ones likely to give good returns in the long run, no matter what the share price is. So don’t get fooled into buying penny stocks just because the price is low. Also, keep in mind that not all low-priced stocks are poor quality, so, do your basic research on financials and management before buying or rejecting a stock.