The remarkable consistency with which the pattern—80% of results come from 20% of causes—appears in our day-to-day lives is astounding if you look around. The Pareto Principle, a ratio, is applicable when researching possible stock purchases, particularly penny stocks. Seth Klarman, one of the world’s most well-known and successful investors, is seen below using the same ratio.
Information is often obtained according to the well-known 80/20 rule, which states that the first 80% of the information that is accessible is gathered in the first 20% of the time. There is a declining marginal return on the in-depth fundamental investigation.
The idea is that conducting in-depth research on equities can be futile. Instead, you should focus on the top 4 or 5 factors, purchase the stock at a significant discount, and then hold onto it since there will be significant upside potential even if something goes wrong. It should not surprise us that this is the strategy suggested for how to invest in penny stocks, which can be lucrative and risky if not handled wisely.
If thoroughly investigated and chosen, stocks with a core business strategy and modest share prices of 50 rupees or less are not outrightly speculative and can give significant potential to generate good profits.
The potential of penny stocks
Heard of Star Paper Mills or Tamil Nadu Petroproducts? How about Graphite India Ltd.? Does Tanla Platforms sound familiar? Yes, they are penny stocks. However, these aren’t your typical penny stocks. These are the stocks that investors have focused on during the past few years at various points. Here is what they gave back over a year.
- The Star Paper Mills 4-bagger (the Year 2016)
- In Graphite India, an almost 10-bagger (The year 2017)
- A 3-bagger in Tanla Platforms (the Year 2017)
- A nearly 10-bagger in Tamil Nadu Petroproducts (the Year 2020)
They emphasize the tremendous earning potential of profitable penny stocks if one uses the proper strategy.
Five ideas may be considered as being of paramount importance when selecting the best penny stock.
1. A healthy balance sheet
Too much debt is one of the primary causes of business failure. Debt works well for them in prosperous times, but leverage has consequences when the cycle reverses, and the company slows down. The debt-to-equity history of the stock you are considering should be checked. The business has a giant red flag if it is constantly less than one.
2. Promoters’ Stake in the Company
What do you prefer, a business where management has little stake or one where management has a significant stake? The latter, isn’t that what it will be? Long-term shareholder wealth creation often receives excellent attention in businesses where management holds a sizable stake. According to research on Seeking Alpha, between 1988 and 2010, a portfolio of such firms outperformed the market by 5% yearly when the CEOs of those companies owned 10% or more of the business overall. Therefore, if the promoter ownership in the firm is 30% or more, an investor should be seriously interested in the world of penny stocks. Anything less should raise a warning.
3. Long Term Business Viability
This is maybe the only part of the framework that emphasizes qualitative analysis above quantitative analysis. Additionally, it is forward-looking and does not, unlike other components, derive information from historical data. It will be a significant warning sign if the business is in a declining sector and has routinely reported declining revenues. It is good to take into account provided that the company strategy is viable. This element primarily prevents getting caught in a value trap in a dying industry.
4. Revenue and profits
The business should have a track record of consistently earning bottom-line profits. However, if the company’s prior performance reveals frequent losses, it should be abandoned immediately. Additionally, stocks that are falling now but are part of a fast-growing business and promise to turn a profit in the future, should be avoided. Such stock purchases are strictly non-advisable as long-term investments since they fall under speculation. No matter how bright the future, the company should be profitable at investment.
5. Deep Discount in Valuations
The margin of safety concept would have been the declaration to pass on if the financial world could do so. The fundamental idea behind it all is to purchase the company at a discount to its actual value to limit the downside in the event of a negative outcome and maximize gains in the event of a positive one. In principle, buying stocks with a margin of safety is simple, but when put into reality, we’ve seen many investors lose their minds. For this reason, only consider a stock if it is trading at a significant discount to its book value, preferably a discount to its net-net value, which is the sum of all net current assets minus all liabilities.
How much money should be allocated to penny stocks?
Blue-chip or mid-size stocks are fundamentally less risky than penny stocks. On the plus side, they offer a tremendous opportunity for progress. A solid penny stock frequently becomes a multi-bagger in a couple of years. Because of this, penny stocks are not advised for individuals with limited risk tolerance. Even slightly more risk-averse, we advise against investing more than 5%–7% of one’s portfolio in penny stocks.
According to Peter Lynch, no one can be 100 percent correct in this industry. It will be a fantastic accomplishment if you are right, 6 out of 10 times; this is precisely what our effort will be.
In addition, losses of between 40% and 50% on a few penny stocks are inevitable. In something as high risk as penny stocks, it should be taken care that the negatives are minimized before concentrating on the potential of something as high-risk as penny stocks.
It should also be remembered that significant risk often results in huge rewards; thus, penny stock investing may be the best decision. Investors with an aim to create wealth should look into penny stocks only after conducting thorough research. We hope that if you carefully review the information in this blog, you will invest wisely in penny stocks and amass riches for yourself. Happy Investing!