Penny stocks look cheap, but the risks can be expensive

Recently, Securities and Exchange Board of India (Sebi) chairperson Tuhin Kanta Pandey said the regulator is working on delisting companies with no economic activity, particularly penny stocks.

“These companies pose a potential danger to investors, and therefore, it is necessary to remove them from the listed space. We are making efforts towards their delisting,” the Sebi chairman said.

Penny stocks are popular among retail investors. The lure of making large gains quickly with a small investment draws many to these shares. But their low prices can mask weak business fundamentals, poor liquidity and the risk of market manipulation. Here is a look at the risks they pose.

Value traps

Penny stocks are typically priced in single digits to low double digits. Several retail investors see a low share price as an opportunity to buy a stock near its bottom. But this is a flawed understanding.

Deepak Jasani, an independent market expert, says several penny stocks have lost value during difficult periods. “Investors think that because prices are so cheap, it is unlikely for such stocks to see further correction and hence there is a margin of safety and the potential for profit is large. But this is not the right understanding of margin of safety,” he added.

In several cases, these stocks may turn out to be value traps. A stock may appear cheap on price-to-earnings multiples or other valuation parameters, but remain undervalued for years because its deteriorating business fundamentals are beyond repair.

Liquidity trap

Another risk is a lack of liquidity, which makes penny stocks more susceptible to market manipulation and sharp price swings.

These stocks are often used by market operators for ‘pump and dump’ schemes. Such operations involve artificially inflating a stock’s price through multiple buy orders. With limited liquidity and weak price discovery, even a sudden spurt in trading volumes can move a penny stock sharply in either direction.

Once the price rise attracts enough buyers, operators begin selling their shares to exit and book profits, leaving late entrants exposed to steep losses.

Sharp price movements can also push these stocks to their circuit limits. If buying volumes dominate, a stock can hit its upper circuit, temporarily suspending trading. If selling pressure dominates, it can hit its lower circuit, again leading to a suspension of trading.

There are often instances when a stock keeps hitting circuit limits over successive trading sessions. For investors desperate to exit, a lower circuit can become a trap, leaving them unable to sell while their losses continue to mount.

Promoter risk

Investors should also be wary of other risks when buying penny stocks. Promoter pledging, for instance, could be higher in these companies, which are often loss-making, leveraged and have limited access to credit.

“Promoters of such companies may be forced to collateralize their own shares to raise borrowing at personal or company level. A higher percentage of promoter pledging could mean that the promoter could potentially lose ownership of the business if he is not able to meet the margin call in time, when the stock is on a downtrend. A lender-driven selling can further push down prices and erode the value of the shares. Often in penny stocks, promoters influence the stock price movements to the detriment of minority shareholder interests,” said Jasani.

A margin call occurs when the value of pledged shares falls below a stipulated level, prompting the lender to ask the borrower to provide additional collateral or repay part of the loan to maintain the required security cover. If the borrower fails to do so, the lender can sell the pledged shares to recover its dues.

Penny stocks are also rarely covered by brokerages and analysts. As a result, information on their business outlook, current fundamentals and recovery plans is often limited. This lack of scrutiny can create further risks. For instance, a promoter may have pledged shares of the company to borrow funds for other businesses rather than for the company’s core operations.