The Pros & Cons Of Investing In KLSE Penny Stocks

Many counters have been heavily battered following the recent stock market meltdown, and they continue to trade at historically low valuations. What’s even more attractive is that many counters, including some fundamentally good ones, have now (Dec 2008) become penny stocks and the list keeps growing as the bear continues its rampage on the market.

In Malaysia , penny stocks are defined as counters that trade below RM1 per share.

Under normal market conditions, penny stocks do not attract much interest, particularly among institutional investors, because they are deemed too risky and their returns rather insignificant to justify investment.

This is because penny stocks are usually associated with smallish companies that are less resilient, and do not have a sustainable business model. The reasons for these counters being quoted at low prices are because of the recurrent losses from their business operations and the extremely negative perception about their quality.

Nevertheless, to some retail investors, penny stocks are cheap counters that could sometimes do wonders and provide decent returns.

At face value, these counters are highly affordable. And because they trade at such low prices, penny stocks have a limited downside risk. This is possibly one factor that could attract some buying interest, particularly in the current (Dec 2008) volatile market condition, as investors seek to cap their losses in the event their equity investments turn sour.

However, investors are cautious against being carried away with penny stocks that may appear to be attractive. This is because many of these counters are inherently risky and have a higher chance of crashing out of the market in bad times.

Generally, investors should base their buying decision on the valuation of a stock, and not its absolute price because most of the penny stocks are not worthy investments.

But if penny stocks are their flavours, investors are advice to do a thorough background check on the companies before jumping on the penny-stock bandwagon.

Investing in penny stocks need more research and monitoring compared with blue-chip counters, and investors need to be alert and watch out for news affecting the companies.

Investors who are considering buying penny stocks to look for counters with good fundamentals and those that attract strong volumes. As in any investment, ensuring that a counter has good business fundamentals is very important, otherwise investors can face difficulty when they want to dispose of their shares later on.

Investors should also consider the sector in which the penny stock operates to ensure that the counter can still generate positive earnings in the midst of a challenging economic environment. Counters operating in defensive sectors such as consumer food, utility, gaming and rubber gloves have a higher chance of riding through the crisis.

Another criteria to justify a penny stock investment, is that the companies must have sufficient cash flow or the ability to generate short-term cash to last them through the economic slowdown, otherwise investors could risk losing their entire investment in the stock. A company’s cash-flow position helps to gauge whether the company can remain as a going-concern when the economy enters a difficult patch few months down the road.

Pay attention also to the gearing level of the companies, and compare that to their industry average; highly geared companies are generally not preferred because they indicate higher risk.

Among the penny stocks favoured include counters such as KNM Group Bhd, Dialog Group Bhd, Scomi Group Bhd, SapuraCrest Petroleum Bhd and Alam Maritim Resources Bhd. Other penny stocks that also look attractive to some of them are Sunway Holdings Bhd, Zelan Bhd as well as real estate investment trusts, or REITs.

Having penny stocks in the portfolio can be a good idea if the counters have strong business fundamentals but investors have to be prepared to hold on to these stocks for the long term to see decent returns.

Most penny stocks do not have institutional following; therefore, it is difficult to push their prices up. Generally, they are also thinly traded, which makes them relatively less liquid and difficult to sell. So, the prices of some penny stocks can remain stagnant for quite a while

Turnaround for penny stocks tends to be longer, hence investors have to be patient enough to be able to enjoy the upside potential of these counters. Certain penny stocks have the potential to offer investors multiple gains over the long run at current (Dec 2008) entry levels.

For instance, some penny stocks are actually worth more than twice their current (Dec 2008) market prices based on the company’s future earnings potential. These stocks are currently (Dec 2008) trading at penny-stock levels due to poor market sentiment. When the market rebounds, these stocks are expected to gradually recover to their fair values.

The current market valuation may be cheap (with the KLCI having fallen by more than 40% year-to-date), but many investors dare not take up long-term buying positions yet for fear of a “value-trap” – a situation where they are drawn into buying an undervalued stock, only to have the stock price decline even further after that.

Due to the prevailing uncertainties and volatile market condition, most investors are currently trading only for the short term for potential ‘bear-market rally’.

But even as stock prices continue to fall, equities as an asset class will become even more appealing from the long-term point of view. This is particularly so in the midst of low interest rates and high inflation that eats up the real value of our bank savings.