Penny stocks may boom but your picks may not

Promoters, manipulators may be driving up scrips.

Ramnikbhai Sheth is a small-time stock market player who prefers punting to investing. Ask him to explain, and he says candidly: "I do not have the money to buy high-value blue-chip scrips or even the much publicised mid-cap counters. I prefer to buy small-value scrips (read: penny stocks)."

Ramnikbhai made a small fortune last year, as prices of most penny counters surged. He explains his fascination with two-bit stocks thus: he has seen the market rally and fall many times but it is the penny counters that surge the most.

Not that he believes in these companies. "Most of these stocks have actually no intrinsic value and will fall the hardest when the market falls or the operator exits," he says.

There is no shortage of Ramnikbhais on Dalal Street. Their logic is simple: it is easier to visualise a Rs 2 share rise 100 per cent to Rs 4, than to see an Infosys double from Rs 2,000 to Rs 4,000.

The numbers certainly are on the side of the penny-stockpickers. Between end-December 2003 and end-December 2004, penny stocks "" scrips that usually trade below their par values "" have beaten the Sensex hollow.

The market capitalisation ""- the number of shares of a company multiplied by the price of the share on a particular day ""- of these stocks surged 85 per cent during the year, while the benchmark Bombay Stock Exchange (BSE) Sensex climbed only by 13 per cent.

Even the broader BSE 500 index went up by only 17 per cent during the same period. And this punting is not limited to only the penny counters; many small-cap and mid-cap companies with no obvious intrinsic value have ridden the rally over the last year.

The recent fall in the Sensex has brought penny ('kachra') scrips back into the limelight. Some of these stocks have surged by 1,500-2,000 per cent or more, which means they could have an even harder fall when stock manipulators decide to dump them.

It could leave many Ramnikbhais hurt. Says Jitendra Panda, vice-president, Motilal Oswal Securities: "Most penny counters and 'rogue scrips' run by operators have seen a huge surge but these counters will also be the worst hit when the market falls. That is when the small investor, who typically buys such shares, will be hit. He will run from pillar to post abusing the equity market."

Says Rajesh Kamdar, a dealer at KG Vora Securities: "Many investors want to be part of the rally. But they cannot buy high-value frontline scrips and hence they get into lower-value counters. Some of them end up buying shares of bad companies without realising it."

The records show that a huge number of small companies got themselves relisted last year to take advantage of a booming market. Since January 2004, more than 200 companies have got themselves re-listed.

Some of these stocks were delisted by the exchange for non-compliance with various clauses of the listing agreement. A few of them failed to submit their quarterly results, and some failed to declare their book-closure dates.

Many of the companies that have been relisted have done so for normal reasons, too. Most of these companies are from the B and Z groups. The spurt in valuations of mid-cap stocks has also led to an increase in the average number of B and Z group stocks traded on the BSE.

Market players suspect a promoter-broker nexus could be involved in pushing up the prices of penny stocks, with the latter enticing retail investors with excellent 'buy' reports.

The regulator keeps a tab on trading activity, but many brokers are smart enough to evade notice. Exchange officials say they also keep a wary eye on unnatural movements in scrips, but the sheer number of penny stocks makes surveillance tough.

Market players feel the regulator must take more stringent action than merely transferring such companies to the trade-to-trade list. "Action needs to be more proactive and taken well in advance," they add.

The broker-promoter nexus is alleged to work in the following manner. It starts with the promoter giving the broker a tip that his company may be about to receive a big order, following which the broker picks up a large chunk of stock.

This sudden buying activity is enough to raise the price of a Rs 2 stock to Rs 4 or Rs 6. This story is then passed around to other members of a broker coterie, and the collective buying interest raises both volumes and prices, making the rally appear genuine.

As brokers start passing the good news around to clients, retail investors start getting into the act, and soon enough "genuine" retail interest pushes the shares up further.

At this point, the promoters and brokers start disinvesting, steadily sending the share's price downwards. The promoters make a killing by selling high and buying back the shares when the share hits bottom once again.