Why you should shun penny stocks

Most of the stock market investors scout for scrips that can make them rich "" and in quick time.

And the get-rich strategy often revolves around buying shares of small companies, which might zoom fast to strike a fortune, rather than buying stocks of blue-chip companies that run established and successful businesses and have made their marks on the bourses, already.

In other words, the idea is not to invest in Infosys Technologies but to spot the next Infosys - the next big thing, as they say. Just a couple of such stocks can make you rich and wipe out losses in the rest of your portfolio. Great strategy. However, the key to this strategy's success is to find out the right company, and is the power to stay put irrespective of any market conditions. But, if you are unlucky, even this approach may not hold water.

In the last one month, the BSE Small-cap index has lost 20 per cent "" three times the loss the Sensex has suffered. During the period, the Sensex has fell only 6.21 per cent.

Obviously, this only underscores the kind of risks associated with all small-cap stocks. Usually, there are three common grounds that drive penny stock purchase decisions. And all of them are bad reasons to pick penny stocks. Here is why:

It's cheap and can appreciate faster: Most people ignore large stocks thinking that there is a limited scope for appreciation in 'high-priced' stocks and they can't own enough of them. So, they would rather buy low-priced stocks and own much more of them.

However, the reality is: the absolute value of the share price really does not make any difference to your returns in the ultimate count. Earlier, when stocks were not available in dematerialised form, there were minimum lot sizes for buying stocks, which catapulted certain stocks beyond the reach of small investors.

But today, an average investor can buy a blue-chip like Infosys for as little as Rs 2,500. While there is some truth in saying that a stock with the share price of Rs 25 could double much faster than a stock with a share price tag of Rs 2,500, the reverse is also equally possible.

My broker told me to buy: Price manipulation is rampant in small stocks. The promoters of a small company often collide with brokers and pump up stock prices hoping that they would be able to hype up the stock and dump it eventually on retail investors. So, it may be risky to base your decision on a broker's advice alone.

Similarly, in the process of ramping up stock prices, the promoters may indulge themselves in a lot of publicity stunts and issue announcements stating a revival in business or big new order or a new acquisition etc.

They may also cook up their books and show profits after registering years of losses. Investors thus need to differentiate between what is genuine and what is fake. It's not easy to validate many of these details unless you have the resources to do so and are into it full time.

*If large FIIs are already investing in it: These days there is a lot of talk about foreign investors entering mid-cap and small-cap stocks. But information like this needs to be examined carefully.

The reality is that a number of reputed foreign institutional investors (FIIs) do not buy these stocks for the sake of their own portfolios. Several of them issue participatory notes to their clients who may be overseas investors linked to the Indian promoters of respective companies.

Currently, the disclosures do not capture this distinction. Since it is difficult for most investors to make out which ones of the FII sub-accounts are their own funds and which ones are for unrelated clients, it may not be an indicator of the quality of the stock.

Investing in penny stocks is not easy. First, there are very little information on and research works in penny stocks available,

In fact, large institutions also refrain from investing in small stocks for want of proper research and analysis. Besides, most penny stocks are either in their formative years or are struggling to survive amid tough financial conditions or bad business environment. To predict a reversal in trend may require insight into the business and understanding about the quality of management and leadership.

Another problem is liquidity. If you are stuck, you are stuck indeed. In the past few sessions, several small stocks have been locked up in the lower end of the circuit for many days on the trot. It may not be easy to take corrective action when negative news strikes as the exit window may just be shut by the time you realise.

Investing in penny stocks can surely be a get-rich strategy, but it involves a lot of risks, costs and efforts to succeed with penny stocks, which small investors can't afford.