Truth about Penny Stock

This is like an everyday thing on investor forums in India. Traders and investors give unachievable and exaggerated recommendations, which 95% of the time are a hoax and meant only for personal gains. But, can 1000's of random messages affect and cause a fluctuation in the price of the stock? It definitely can. Not every company is Reliance with a Rs 10,000 Billion market cap. There are numerous mini-companies, which get listed in the stock market, (Not necessarily NSE or BSE, but various other exchanges) who want to raise a few hundred crores of capital. It is a good opportunity for them to get public funding. But, because of the fewer number of shares and volumes to trade, these stocks get manipulated by false marketing. These are called penny stocks. In India, they are usually below Rs10. They are also called nano-cap stocks, micro-cap stocks, and small-cap stocks, depending on the company's market capitalization. This blog is predominantly about penny stocks and the biggest scam dominating it, called Pump & Dump.

You must have all loved watching the movie, 'The Wolf of Wall Street'. It was about a former stockbroker who indulged in fraud and stock-market manipulation. Jordan Belfort founded Stratton Oakmont and marketed penny stocks to defraud investors. How is it done? Brokers promote penny stocks through intensive marketing using cold-calls. Belfort was good with words and hence, could convince ignorant people. In this digital era, penny stocks are promoted through emails, newsletters, videos, social media, and investor forums (just as above). If you get an email hyping up a stock, without mentioning the risks and emphasising the flowery parts, it's probably a scam.

The perpetrators drive up the prices by marketing the stock and convincing people to buy. These perpetrators already have an established position in the stock and sell their stocks after the hype has led to a higher share price. Due to active selling, these stocks fall back to their low prices, with new investors bearing massive losses and these perpetrators leaving with plenty of quick bucks. This is what you call, Pump & Dump. You pump the prices and dump your shares. At Stratton Oakmont’s highest point, they had employed over 1000 traders who issued stocks over 1 Billion dollars.

If X stock is at Rs1 and moves up to Rs1.1 tomorrow, that is 10% returns in just 1 day! Hence, penny stocks are very eye catchy and I believe Pump & Dump is one of the biggest frauds in the stock market. Investors lose their entire life’s savings in such schemes.

But does that mean, you shouldn’t invest in them? No. They are potentially multi-baggers and people earn a fortune through them. The growth potential of a good penny stock far exceeds its large-cap counterparts. In fact, many big companies you see today were once penny stocks. Titan traded in the range of around Rs2-4 in the year 2000 and currently has a market price of Rs960.

Penny stocks are usually illiquid, which means they trade infrequently/lack of ready buyers. The pricing of these shares is unpredictable and there's little information available to the public. For example, when you pump the stock, it becomes overvalued, but this information is hard to find. This makes it difficult for an investor to make an informed decision.

So when you invest in a penny stock, it is very important to conduct good market research. Understand its business and focus only on fundamentally good stocks.

Traders usually get into penny stocks with a predetermined stop-loss order. It is the price at which you want to exit the stock if the market moves in the opposite direction. Stop-loss once triggered will automatically sell the stock saving you from huge fluctuations in these penny stocks.

To know more about how to research stocks through qualitative analysis, have a look at my previous blog here- https://www.balancingaf.com/post/personal-guide-to-equity-research.

Write-up by: Chaitya Sanghavi