Penny Stocks Investing Strategy for 2024

The current bull market has made the headlines for the Nifty and Sensex scaling new all-time highs of 21,000 and 70,000 respectively.

Recently, the Indian stock market became the 7th largest stock market in the world by marketcap, overtaking Hong Kong.

However, the biggest story of the market is the participation of retail investors in the broader market outside the stocks that make up the benchmark indices.

Midcaps and smallcaps have been at the forefront of the rally. These stocks have created significant wealth for shareholders.

However, the most popular category of stocks over the last few years has been, without a doubt, penny stocks. Retail investors just can't get enough of them.

So, let's take a deep dive into penny stocks and find out the best investing strategy for these stocks...

Why Invest in Penny Stocks?

Penny stocks are investor favourites because they hold the promise of providing huge gains in a short time. We're talking about the possibility of making multibagger returns in just a few years as opposed to many years in the case of most other stocks.

By multibagger returns, what exactly are we talking about here?

Well, investing in penny stocks is not an easy task but well-chosen and fundamentally strong penny stocks in India have the potential to deliver profits greater than 1,000% within 1-3 years. This is almost impossible in the case of any other category of stocks.

This is the main reason for their popularity. Investors are aware of these potential gains and are constantly on the lookout for fundamentally strong penny stocks.

What About the Risks?

Penny stocks are without a doubt the riskiest type of stocks. They can crash anytime for any reason. They are infamous for wiping out 90% of investors wealth in a few weeks or months.

Even worse is their low liquidity in most cases. With only a limited number of shares being traded on any given day, a small increase in volume can move the stock in a big way.

This is great if the stock moves up but disastrous in case of a decline as most investors won't be able to sell at a decent price.

It's common to see penny stocks plunge 80-90% when the market enters a downtrend. This is why investors should be extremely alert and cautious with penny stocks.

Then there is the mistake of overallocation. Often many retail investors think they can make a fortune in penny stocks. So, they invest most of their funds into one or just a few penny stocks.

The result is usually a disaster. There is no shortage of stories in the stock market of people losing their life savings in penny stocks because of overallocation.

So how do you invest in these stocks the right way? What's the best strategy?

Before we discuss that, there are two things you should know about penny stocks.

• First is the big myth of penny stocks.
• Second is the harsh reality of penny stocks.

Once you're are aware of these two points, we can get into the strategy of investing in penny stocks.

The Big Penny Stock Myth: Penny Stocks are the Best Way to Get Rich Fast

You've probably heard this one. Even those who don't actively invest in the stock market may have heard this myth.

In a bull market, more than a few penny stocks will do well. Some will, most certainly become multibagger penny stocks.

This convinces retail investors than penny stock investing is their best bet to get rich in the stock market. What they don't realise is that investing in penny stocks is perhaps the best way to destroy their portfolios.

Why?

The answer is found in the next point...

The Harsh Reality of Penny Stocks: Most Penny Stocks are Toxic

Penny stocks are plagued with many issues - sluggish revenue growth, low margins, losses, high debt, low promoter holding, high promoter pledging. They are not considered prudent investments.

If you invest in such toxic penny stocks, you're risking the safety of your hard-earned money.

Just think about it. Would you invest in a large-cap stock if the company had a history of making losses?

I'm sure you wouldn't.

So, you shouldn't invest in bad penny stocks either. Just because these stocks can go up a lot is not a good enough reason. The risk-reward equation is not in your favour.

If these stocks crash, your capital will be at risk. Even worse, many penny stocks, unlike blue-chip stocks, don't recover after the crash.

So, how do you find the best penny stocks?

The Best Penny Stock Investing Strategy: Look for the Top 1%

The only penny stocks worth your time and money are the best 1%. They are the only ones that will likely not crash 80-90% and also most likely to rise 10x or more.

All the stories you've heard about penny stock changing the lives of investors by making them rich, are stories of the best 1% of penny stocks in the market.

Most people don't realise this. They think one penny stock is similar to any other. Thus, it doesn't really matter which one they buy. Nothing could be farther than the reality of penny stocks.

If you don't do your research and carefully filter penny stocks before taking a decision, you will most likely end up with the bottom 99% instead of the top 1%. This will result in big losses sooner or later.

How to Find the Top 1% of Penny Stocks

Now for some good news.

• First there’s a straightforward way to narrow down the list of penny stocks to the top 1%.
• Second there’s another straightforward way to select the best penny stocks from the top 1%.

Here's what you need to do...

Steps to Filter Penny Stocks

1. Avoid all penny stocks that have high debt. By high debt, we mean the debt-equity ratio should be less than 1. Ideally, the ratio should be less than 0.5.
2. The company’s owner should have significant stake. Reject all penny stocks in which the promoter has less than 30% stake. Also, pledging of shares should be a strict NO.
3. Look for long-term business viability. Penny stocks can deliver great returns like 50x and 100x in the long term. For that to happen its business model should be viable. Look for companies that are likely to be around at least a few years from now.
4. The company must be generating an income. By income generating, it must be profitable today. If the promised profits are in the future and the companies are making losses today, stay away.
5. Filter by valuations. They should be deeply discounted, not just cheap. This is also a great way to minimise risk. If a stock is already trading a deeply discounted valuation, then the market has already factored in any bad news.

Steps to Find the Best Penny Stocks

After you have filtered down penny stocks to the top 1%, you have to shortlist the few you want to potentially invest in.

To do that, follow these steps...

1. Strong balance sheet: Look for low debt, high cash balance, and a current ratio greater than one i.e. the current assets should be greater than current liabilities. Equitymaster’s stock screener can help you find debt free penny stocks.
2. High promoter holding: The higher the better. It shows the promoter has skin in the game. Promoters buying shares from the market is a good sign. Use Equitymaster’s stock screener to find stocks where promoters are increasing stake.
3. Quality of the business: Ask these questions. Is it a good business? Are the fundamentals strong? Will it be around after a few years? Is it making profits? Use Equitymaster’s stock screener to find profit making penny stocks.
4. Cash flows: Does the business generate cash from its operations? If yes, then is it growing? How is the cash being used? Also check out this list of cash rich penny stocks.
5. Cheap valuations: It’s always a good idea to buy penny stocks when they are cheap. Check if the stock is trading below its book value. A margin of safety of at least 20% below book value is a good entry point. Check out this list of undervalued penny stocks in India.

Conclusion

In the stock market, penny stocks belong to the category of, 'highest possible risk for the highest potential return'.

While they present potentially the biggest upside potential of any group of stocks, they can also erode wealth faster than any other group.

This is the reality you must accept when investing in penny stocks. Even if you have a high-risk profile, we recommend not more than 5% of the portfolio be invested in penny stocks.

You can start you're search with Equitymaster's stock screener to find the best penny stocks. The screener allows you to screen stocks based on your own criteria.

Investing in penny stocks is not rocket science but it requires you to practice extreme caution. On the other hand, if done correctly, picking the right penny stocks will significantly boost your portfolio's overall returns, especially in the long term.

Finally, we suggest reading Equitymaster's Ultimate Guide on Penny Stock Investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...