Why Penny Stock Investing isn’t Synonymous with Blind Gambling

By SmartProInvesting.com Stock Investing Team.
May 2, 2008

Penny stocks, you probably know are low-priced stocks. In Naira terms, you would think of stocks selling at below N5, possibly slightly higher. With such low prices, why wouldn't investors concentrate on buying them, you'd be tempted to ask. Let's say straight off that penny stocks are cheap because they generally have one weakness or the other. If a company shows strong performance, the market readily rewards it with price growth. Staying low means that the market has not seen a good basis to respond with price increases which result from increased demand.

That is a general comment. However, in reality, there could be companies down there that are doing great things that will eventually prop them up. That is the basis of penny stock investing: finding such companies and cashing in before the results begin to show and the market then discovers.

When it comes to investing strategies, penny stocks have their following and that includes very accomplished investors who devote time to searching out money-making opportunities in penny stocks. The attraction to penny stocks stems from the perception that:

  • their prices could record substantial growth, almost unnoticed, with relative ease. A 20 kobo rise on N2.00 is already 10%, yet a N5.00 gain is only 2.5% if on N200.00. While the absolute gain would appear negligible, in relative terms it becomes substantial because of the smaller denominator (current price).
  • bargain purchases are also possible. Some stocks have lost favour or haven’t just come into serious reckoning with the market, leaving their prices at penny level, even with underlying relatively strong fundamentals. Penny stock investors identify and cash into such bargain opportunities which easily mean subsequent profits.
  • penny stocks seem more affordable, just in the sense that larger numbers can be bought. That is not necessarily an advantage, except that it gives a feeling of larger holding.

That category of stocks has lately caught accentuated interest in our market, a good reason to keep examining investor action in that sector. On that count, indications are that a significant number of investors may not understand the driving force in penny stock investing. That could lead to errors that might cost good money. The reason is that many investors are blindly speculating on price appreciation without much thought to the basis of such appreciation.

Intelligent investing isn't just about how much profit you aim to make immediately, even though profit is at the root of the investing process. Coming out well, in the end, is the final goal. If you are driven exclusively by the profit objective, you could easily fall for perceived high-earning opportunities that expose your investment to extreme risk. That's what it begins to look like when investors log money into stocks on purely speculative basis, especially when there is no serious underlying corporate performance to support the action. Investing in moribund companies in the hope that the prices are pushed up does look highly risky.

Penny Stock Investing Strategy
So what do the experts in this field buy and how do they find them?

Tutored penny stock investors seek to buy real hidden value - stocks that are priced in the penny region but which command some strategic and competitive strengths that assure future performance that will drive up the price. That is not as simple as looking up the exchange price listing for stocks their prices have not moved in months and years and attempting to pull them up through buy orders. Penny stock investors do a lot of investigation of target companies, carefully analysing their operations to determine strengths that can see them grow their businesses to attract capital appreciation. In effect, expectations are based on the strengths of the company, which may not be obvious to the market presently, hence the current low pricing. The result here is that when the prices of such stocks begin to go up, it is because the results and potentials are becoming obvious to the market.

That approach contrasts with a situation where prices are driven up, simply through speculative orders. In the end, their is no business growth to support the price level. In some cases, the businesses are inactive. What will happen is that ultimately, there will be no earnings to support the new price level. It simply can't hang there, since there is no substance to prop it. Invariably, it will crash. Unfortunately, some who bought at the peak will lose money. That what the experts have said.

Penny stocks, by their nature, are extra-risky investments. The reason should be clear - they are generally weaker, smaller companies, which is why they are low priced anyway. The stocks are also more difficult to sell off and that illiquidity raises the risk. When you want to invest in that sector, do so on targeted basis: evaluate companies as to what they are doing and plan to do, their competitive advantages and other strengths and if the numbers support strong growth expectation, it would make sense. For companies that are dormant or dwindling, with no immediate effort to support any expectation of a brighter future, buying because prices are being pushed up could be a big gamble.

 


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