Are 'Low Priced' Stocks Cheap?

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"Games are won by players who focus on the playing field - not by those whose eyes are glued to the scoreboard." - Warren Buffett

Ask investors what they look for while investing in stocks. The answer in majority will be stocks prices, and a rare mention of business fundamentals. While it is true that cheap bargains leave a room for enough margin of safety, many people fail to understand the difference between the price and value of a stock. And as a result of this, many low price stocks are considered as cheap. Needless to say, the Indian stock markets abound in myths and false beliefs. But let us try to dispel one of them today.

The general assumption of investors is this: Low-priced stocks are more profitable than high-priced stocks. They understand that a stock trading for Re 1 will turn more profitable than a stock that is trading for say Rs 1,000. There are also many arguments that people have to back this theory. Some are of the view that it's easy for a Rs 1 stock to multiply several times, but how far can a Rs 1,000 stock really go? Moreover, one can buy a cheap stock in ample quantity which cannot be possible with the latter. And many more reasons of the like. Still, however compelling these reasons may seem, the truth is never very different.

Before we jump into explanations, the above stocks that we are concerned about are referred as penny stocks. These stocks are typically stocks priced below Rs 10. They trade at low prices, with less market capitalisation and are not a part of any major market index. And usually they are the centre of attraction for retail and amateur investors. These investors buy into these stocks hoping that over time the stock price will appreciate and the stock will be the next multi-bagger. However, is it the case so? Let's found some data to answer that.

An article from the Hindu Business Line opines that penny stocks have had a poor run in 2016 so far. In the period between in January and August, only three out of every ten such stocks have delivered positive returns. The information we are looking here is for 130 penny stocks - the present number of such stocks that are traded on the BSE. From this lot, more than half are down above 20% so far this year.

The reasons behind this drab performance are many. First, these companies have poor record for financials. The article notes that two-thirds of these penny stocks are of loss-making firms. Among those that are not, the profits are negligible. This has resulted in erosion of assets for these companies, which has further resulted into negative net worth.

Next, we have governance issues. Low levels of disclosures coupled with governance problems have increased risks manifold.

Apart from all the above, these businesses are drowning in troubles. Their return ratios show that the management of these companies is inefficient in deploying shareholders capital.

On the contrary, the same article mentions the bright side of penny stocks. It states that while the performance of such stocks have been tepid in 2016, they have done quite well in the period between January 2014 and now. All the 147 stocks that traded below Rs 1 in January 2014 have delivered gains to investors, with an average gain of 264%. Further, almost 60% of the stocks managed to double their price and a third of the stocks have given more than two-fold returns.

This leaves us to the moot question: Should one bet on penny stocks? Do they offer huge prospects of higher returns?

What one should understand is that penny stocks are one of the riskiest segments in the Indian stock markets. They are highly illiquid and their prices can be influenced by stock market operators. So while the prospects of gains could be huge, the chances of losses are equally high. And if one has to follow Warren Buffett, not losing money in the first place is the key to successful investing.

We believe the way one can profit from such stocks is by understanding the difference between 'low priced stock' and 'cheap stocks'. A 'low price stock' is one that has a low stock price. But please note, it has absolutely nothing about its value or how expensive it is. On the other hand, an 'cheap stock' is one whose market capitalisation (stock price multiplied by number of shares) seems underpriced in terms of its net worth or future earnings prospects.

So one can study the fundamentals of the company that they are investing in. If the company fundamentals are sound and the stock is available at cheap valuations, then go ahead and buy it. Otherwise stay away from it.

Speaking of fundamentals and cheap valuations, our premium report, Sensex 40,000: 4 Stocks to Profit from the Coming Stock Market Wave, is still available. The report explains the undercurrent driving the market that 90% of market participants are currently ignoring.

For information on how to pick stocks that have the potential to deliver big returns, download our special report now!

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