Adventurous or Boring – Penny Stocks vs ETFs

We play the devil’s advocate arguing on why boring is good for our financial health 

By: Tavaga Research

The shares of Eicher Motors were selling for just Rs 21.75 on October 3, 2000. On July 17, 2020 (closing), the share price was Rs 18,875.

That is a whopping return of 40.25 percent (CAGR/the annual rate of return) or a total of 86,681.6 percent in the period mentioned, which is close to 20 years.

Performance of Eicher Motors

Many of us may have missed the opportunity to ride this stellar growth. Some marquee investors claimed to have identified the opportunity early — the possibility of what was little more than a penny stock in 2000 to turn into a multi-bagger stock (a stock giving returns many times its cost price).

Was it then, the best penny stock in India? Are there similar opportunities that are available in the market for which we should scout?

There have been many companies like Eicher which have given humongous returns. Initially low-priced shares, they now rule the markets, making fortunes for investors who identified them early on.

But what are the chances of us picking up a fundamentally good penny stock and sticking with it till it becomes a multi-bagger? Slim. 

Penny stocks are stocks with high volatility and low volumes. So, even a small sell-off, triggered by say, a pessimistic news article, can make the company worthless, hurting our returns in turn.

So, let us try to understand the nuances of the penny stocks in India, and also see what we should look for while investing our hard-earned money in such scripts. 

What are penny stocks?

For the lack of a regulatory definition, penny stocks in India are ones often trading below the price of Rs 10, with a low market capitalization of Rs 100-200 crore.  A low share price characterizes these listed companies. The shares are mostly illiquid, which means that there will not be many transactions taking place during the day, so it may be difficult to buy or sell these shares. 

What draws people towards a penny stock is its low downside risk (ie. the loss suffered if there is a further decline in the already-low-priced stock’s value/price) and the high upside potential (returns generated if the value rises since the initial cost to acquire would have been quite low). The wealth is expected to multiply, especially over a small period of time.  

Before we roll up our sleeves and get into acquiring penny stocks, we should acquaint ourselves with the nuances of such companies. 

Are stocks worth Rs 10 cheap?

This is a classic behavioral mistake we make when we go about investing in a penny stock — invest in one just because it is low priced.

As an investor, we should know that the true worth of an investment is not the price it commands but the valuation it holds.

So, let us rephrase our question.

Is buying a stock worth Rs 10 a good idea?

The answer lies in the valuation of the company offering the stock. 

The most effective ratio, that of the price-earning ratio (PE ratio), helps us assess the relative valuations of stocks and compare them. 

P/E ratio

The PE ratio divides the last traded price of a share with the earnings on a share. 

The earnings on a share or earnings per share (EPS), refers to the bottom line in the financial statements of companies, divided by the number of shares. It is the net income of the company that each share is entitled to. If all the profits were to be distributed among the shareholders, EPS shows how much a share would have earned.

So, the PE ratio tells us what is the multiple of EPS that is equivalent to the share price of the company. The yardstick compares the price of the stock with its profitability (earnings). 

Say, the shares of XYZ company had an EPS of Rs 4 last year and the current share price is Rs 20. It would mean we have to pay five times the earnings of that share to buy it. 

The lower the ratio, the better for the investor. At the same time, especially for micro-cap or penny stocks, the ratio should not deviate too much from the average PE of the industry it plays in. Cyclical industries, which see an ebb and flow in demand with seasons display lower PE ratios while other industries like pharma and IT, a higher PE.

We compare the PE ratio of the company with the average PE of its industry,  considering it as the benchmark. However, if the PE is abnormally low or high as compared to the average PE of the industry, it is considered as a red flag.

While calculating this for a penny stock, the PE ratio works only when the company is profitable because the denominator i.e. EPS will be negative when there is a loss.

So, let us analyze the PE for some penny stocks which have reported profits.

The chart shows how low the PE ratios of some of the penny stock companies are like those of Indbank Merchant Banking, Bajaj Hindustan Sugar, 3i Infotech, Opto Circuits India as compared to their industry’s average which are financial services, FMCG, IT services, and pharma, respectively; this aberration will be considered a red flag among the savvy investors.

So, before buying any such stock, we have to make sure we have a strong and valid reason to back up our investment move.

Subjective call

There is a lot of psychology involved in investing in penny stocks, as these are the companies that have a lot of debt or even, are coming out of bankruptcy. The idea is to make a strong assessment of company management, which is difficult for people like us. 

So, how do we convince ourselves about the prospect of the company? This is where subjectivity comes in — we have to understand the business, the prospect in their story, the scope of the industry.

The pitfalls of subjectivity are many. One of them is the Hindsight Bias.  

When Eicher was selling for Rs 10 a share, there were many others similarly priced, but are now worthless.

The hindsight bias, as explained by Michael M Pompian, in his book, “Hindsight Bias – The Behavioral Biases of Individuals”, may have made some investors say it was to be expected that Eicher would turn out to be a multi-bagger in the next 20 years. 

The bias talks of how people tend to see past events as predictable because the outcome becomes known to us. It becomes more readily evident over other outcomes that did not transpire. The reconstructive nature of our memories make us tide over the discomfort around unexpected events by making us believe that we did predict some parts of what happened because they were expected. 

Investors react similarly to penny stocks that break through the roof and leave ignominy behind.

But predicting the next multi-bagger is an uphill task, even for the most skilled investor. The probability for the average investor to pick out the promising stocks is even lower.

Why investing in penny stocks is a bad idea

There are a plethora of reasons, but here are a few:-

High volatility

Penny stocks exhibit high volatility, which makes them a risky instrument to deal in, especially when the savings of retail investors are involved. 

For example, if we look at the empirical data, there are many penny stocks which have exhibited volatility of more than 50-60 percent in a single trading session, ie. their share prices have moved more than 50-60 percent from their mean value (the average trading price during the past 1 year). The stock exchanges, therefore, keep a close eye on such stocks and also apply circuit breakers to some cool-off time.

A circuit breaker is the price band stipulated by the stock exchange for the price movement of the stock and it stops trading in that particular script for a while as soon as the price goes outside the band (either above or below).

Sanwaria Consumer, which was selling for meager Rs 3 in January 2017, rose to a high of Rs 34.40 in the span of just a year, giving the investor the unbelievable return of almost 757 percent. Unfortunately, it eroded all its gains and is quoting at the price of Rs 1.40 in February 2022. 

So, we can understand that this is a volatile space.

The share price of Sanwaria Consumer Ltd.

Debt-ridden companies

Most of the penny-stock companies are highly debt-ridden with low profits, which means there are higher chances of uncleared dues and subsequent bankruptcy in the companies.

For example, GVK Power and Infrastructure (GVKP) which has a debt to equity ratio of -9.44 times and is trading in the range of Rs 2-3, was once (in 2013-14) projected to become an Rs-1,00,000-crore market-capitalization company. The debt-equity ratio interprets as how much debt a company has as a proportion to their own capital which is equity

Below are the dismal debt-equity ratios of three fallen angels, which were companies regarded as having good fundamentals and prospects only a few years back.

We can see how these companies have high debt, which can be illustrated using the debt to equity ratio. A negative D/E Ratio implies the company’s interest rates on debt are greater than its return on investment, or the negative net worth of the company

Illiquidity

Let us try to understand illiquidity with an example. Say, we purchased a share which was trading at Rs 8.45 at in the early hours of trade on a Monday. A few days later when we wanted to sell the share in the market, there was no one to buy, ie. the bid side of the order book (for the stock) had just three orders, and that too at a price way below our asking price.

This is how illiquidity creates a problem for an investor with penny stocks.

Illiquidity is a situation where security cannot be sold/bought without a substantial loss in value.

Since penny stocks are mostly illiquid, it becomes very onerous to take trade in them.

Pump and Dump (or Scams!)

Retail investors don’t often understand the concept of pump and dump strategy in the stock markets.

On June 9, 2015, several news media reported that a marquee investor had bought 250,000 shares of Surana Sonar at Rs 53.74 each. 

Knowing this, many unsuspecting investors tried to ape the move and bought the stock. They ended up losing their money even as they came to know that it was all just a rumor, spread by a ‘pump and dump’ operator. The stock price tanked by more than 18 percent over the next two to three days. The stock price hit the lower circuit. 

The green arrow indicates when the pump and dump operator released the news in the media, and the subsequent candlesticks show how stock price plummeted when they dumped its shares.

This is a classic example of how the pump and dump scam works.

Penny stocks are easier to manipulate because of their low market capitalization, so investors should beware and analyze the stock before investing. 

What could be the alternative to mercurial penny stocks for the average retail investor? Passive instruments such as exchange-traded funds (ETFs). 

ETFs – the better option

Penny stocks sound very interesting prima facie but delving into them can take us in murky waters. Anyone can easily burn their fingers while picking a penny stock even after days and months of research. Do we have any better ideas? Ever heard about ETFs?

ETFs are a form of pooled investment vehicle. The advantages of the ETF structure include ease of trading, low management fees, and tax efficiency. 

5-Year Performance of SBI Nifty 50 ETF

Unlike traditional open-end mutual funds where you can buy the units directly from the asset management company and also place a redemption request to them, but the units are not listed in any exchange, ETF shares can be bought by investors on the exchange itself; investors can even sell the ETF on the exchange. ETFs, then, enjoy every convenience which a trader has on a stock exchange. 

ETFs, offer flexibility in that they track a wide array of indices.

ETFs have a unique structure that requires a fund manager as well as an authorized participant who can deliver the assets to the manager. The role of the authorized participant is to be the market maker for the ETF and the intermediary between investors and the ETF fund manager when shares are created or redeemed. 

To create shares of the ETF, the authorised participant delivers a basket of the underlying stocks to the fund manager and, in exchange, receives shares of the ETF that can be sold to the public. When an authorised participant needs to redeem shares, the process is reversed so that the authorised participant delivers shares of the ETF in exchange for a basket of the underlying stocks that can then be sold in the market.

The creation/redemption process is used when the authorised participant is either called upon to deliver new shares of the ETF to meet investor needs or when large redemptions are requested. The redemption process occurs when an authorised participant needs to reduce its exposure to the ETF holding and accepts shares of the underlying securities in exchange for shares of the ETF.

Summing up, an ETF is a basket of securities that can be bought or sold in the spot market like common shares. The price of the ETF is the price of all its constituent securities.

The disadvantages of the ETF structure include the compulsion to buy at the offer price and sell at the bid price, commission costs, and the risk of an illiquid market when the investor needs to buy or sell the actual ETF shares, elaborate David M. Smith and Kevin K. Yousif in their book, “ETF- Passive Equity Investing”.

Here is an easy ETF primer and below is a quick look at the salient differences of ETFs, regular stocks, and MFs.

ETFs vs penny stocks

If we look at empirical data, ETFs have given decent returns. These passive instruments are relatively safe compared to penny stocks, which trade on an isolated basis. Penny stocks have run idiosyncratic risks like the death of a key management person etc,  which can upset the cart, whereas, in an ETF, composed of a basket of stocks, we get the benefits of diversification, protecting us from any company-specific mishaps.

While passive investing, and ETFs within that, are well suited for the retail investor, before parking our money in any venture, we should always carry out a risk and reward analysis.

In the case of penny stocks, the risks are too high to be offset by any perceived benefits. 

At the end of the day, isn’t principal protection more important than the greed to achieve supernatural returns?

Tavaga is everything you need to start saving for your goals, stay on track, and achieve them in time. 

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