Penny stocks are always in the news for the wrong reasons. Sometimes, we hear of investors biting penny stocks, but most of the time, we hear about penny stocks biting investors. The number of penny stocks listed on our stock exchanges surely looks larger than the number of stray dogs on our streets. Regulators really have a tough time keeping things under control.
Now and then, we do see regulatory nets coming across, presumably to make streets safer. But do we sometimes go overboard in condemning all penny stocks? Blinded by our own prejudices, do we miss the rough diamonds lying unnoticed?
Johnny: You can take up larger questions later. First tell me, what is a penny stock?
Jinny: Well, let’s talk about first things first. There is actually no official definition of penny stocks in our country. The Securities and Exchange Board of India (Sebi), the stock market regulator, has not prescribed any formal definition of penny stocks, although it has been using this term frequently in its orders and publications. Like many other terms, we have borrowed this term from Wall Street.
The Securities and Exchange Commission (SEC), the regulator of the US stock markets, has adopted a formal definition which puts any stock trading under $5 (Rs243) in the category of penny stocks. However, market participants in the US seem to have a more flexible approach, and the actual cutoffs of penny stocks may vary, with some treating any stocks trading below $1 as penny stocks.
Johnny: There is no universally accepted definition of penny stocks. How do we identify penny stocks in India?
Illustration: Jayachandran / Mint
Jinny: In the absence of any prescribed definition, the Indian stock market has been using an informal definition—any stock trading at a price less than Rs10, or at a price less than the face value, is treated as a penny stock. In general terms, we can say that penny stocks have a small market capitalization due to unsound fundamentals. A typical penny stock is highly illiquid and stock exchanges many a time, put them in special categories such as Trade to Trade (T2T), due to small volumes and chances of price manipulation, or Z category, due to the non-fulfilment of the terms of the listing agreement.
All trades in T2T and Z-category shares are settled only on actual deliveries or gross basis without allowing any netting. So, even when you have sold 100 shares and purchased 90 shares of the same company during the course of a day, you would be required to make a delivery of 100 shares and receive delivery of 90 shares if the shares have been put in T2T or Z category. In cases of netting, you could have fulfilled your obligation simply by making a delivery of 10 shares, which is the difference between the shares you have sold and purchased.
Johnny: So T2T and Z categories are favourite abodes of penny stocks. Tell me, why are penny stocks treated so shabbily by regulators and stock exchanges?
Jinny: Penny stocks have all the qualities for becoming notorious in the stock market. First, they typically have less liquidity, with higher bid-ask spread and a very small trading volume which makes them a soft target for price manipulation. Just out of the blue, a penny stock trading at Rs2 per share may jump to Rs4 per share, showing an appreciation of 100% in just a couple of small trades.
Although not every price move can be termed as manipulation many times, penny stocks fall easy prey to a speculative frenzy. But the danger is that sooner or later, reality is bound to hit the market. What appreciates by 1,000% in a few days can easily depreciate by 1,000% once the mood changes.
Secondly, we should not forget that penny stocks are penny stocks due to poor fundamentals. Many of them are not even in a position to fulfil their listing requirements. Most of the time, you would not be able to get a true picture of the company. So if you are the one looking for a rough diamond in a pile of penny stocks, you would mostly likely be disappointed.
It is wrong to presume that all big firms that we see around were once penny stocks. On the contrary, many big firms made their debut in the stock market only after gaining some maturity. So the chances of a penny stock evolving into a mega stock depend more on a miracle.
But despite all odds, many people like to take the risk. Their biggest lure: a chance of owning 1,000 shares by merely putting, say, Rs2,000 if the shares are currently trading at Rs2 per share. You can place your bets just by putting a small amount of money. That’s just like going to a backyard casino.
Who knows, you might have good luck!
Johnny: Thanks for your advice, Jinny. Although miracles do happen, I would not make any investment purely in the hope of a miracle.
What: Any stock trading at a price less than Rs10 or at a price less than the face value is considered a penny stock.
Why: Penny stocks have less liquidity and small trading volumes, which make them susceptible to price manipulation.
How: To check excess volatility and chances of price manipulation, many penny stocks are kept in special categories where trades are settled on gross basis.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org