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Saturday, January 23, 2010

Know the risks of investing in penny stocks


Investing in stocks is always fraught with risks. There is, however, no dearth of people around who not only invest in low-risk stocks but also in very high-risk stocks such as penny stocks, turnaround stocks and concept stocks because of the lure of high returns, and most of them often end up burning their fingers too.

It is not that investing is such stocks has never been rewarding. Sometimes people make good money by investing in high-risk stocks also. But such instances are very limited. It is better, therefore, to know the risks involved before putting your hard-earned money into high-risk stocks:

Penny Stocks: These are low-priced stocks, typically less than Rs 5 (although there is no set definition). Trading in these stocks happens mostly for speculative purpose. The price movement of these stocks is more driven by trading than by the stock’s fundamentals.

Turnaround stocks: Generally a company that survives bankruptcy is considered a turnaround stock. This definition also applies to turnaround in fortunes of fundamentally-strong companies after they have experienced some hard times. The bad phase can occur due to adverse market conditions, adverse policy and economic conditions or even poor management.

Concept Stocks: Unlike penny and turnaround stocks, concept stocks are those stocks which are likely to create significant value for investors in future and are from sunrise industries or are focusing on new innovative and unique industries, technologies or services.

Liquidity Risk: Usually the large ownership of these stocks rests in the hands of few people like promoters of the company.

“If these people deicide to unload a significant number of stocks, the price drops steeply. Also, since most of the trades are speculative and not really backed by fundamentals, the moment there is a market correction everyone wants to get rid of these stocks, resulting in huge price corrections,” says T Srikanth Bhagavat, managing director, Hexagon Capital Advisors Pvt Ltd.

Trick trades: Going by the past experience, penny stocks’ prices are sometimes rigged and artificially inflated.

“Investors get sucked-in looking at the price movement only to suffer later as prices drop when the traders off-load large quantities of shares,” says Bhagavat.

Corporate governance: Most of the penny/small stocks are poorly managed and governed. Some of them don’t even send their annual reports to investors!

 The risk involved with turnaround stocks is that the turnaround may not sustain, leading to losses.

“The risk in a turnaround share or a concept investment is that of the story petering out. The turnaround may not happen or the concept may turn out to be dud. The dotcom bust is an example of concept investing gone awry,” says Bhagavat.

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