Are Penny Stocks More Profitable?

Many a times it is said that the returns from penny stocks are much higher as compared to large-cap stocks. In this study, we will explore if average returns from low-price stock can generate higher returns for the shareholders. Investors are tempted to invest in penny stocks as they feel that they can buy more number of stocks as compared to when they invest in high-price stocks. Some investors also have this misconception that it is very difficult for the high-price stocks to increase as they have already appreciated. 

Though it is fundamentally incorrect to even compare prices of stocks, and this should never be done, yet in this study, for the purpose of educating investors, we have tried to make a comparison. If companies have to be compared to find if they are relatively cheap or expensive, investors should compare using price earning multiple (PE ratio), EV or EBITDA multiple, price to book multiple (PB ratio) or any other valuation matrix. 

We have undertaken this study using data between 2010 and 2021. We selected top 2,000 shares sorted on the basis of market capitalisation and applied two filters:
✓Market capitalisation should be greater than Rs 100 crore. This filter ensures that we do not include those shares in our dataset which have very small market capitalisation and can be easily manipulated by the traders
✓Share should have return of equity (ROE) greater than 10 per cent in the year of selection as we assume that shareholders would refrain from investing in shares which do not generate minimum ROE of 10 per cent.

Shares which qualify on these two criteria were sorted on the basis of price. For each of the year under study, the number of companies that qualify on the above-mentioned criteria varies. Based on the selected companies, we have divided them into five portfolios with equal number of companies in each of the portfolios. Decile 1 has companies which have higher prices and Decile 5 has companies which are penny stocks. 

In the first table, for the year 2020 we can see that there are 543 companies which qualify on the two parameters and when we divide these companies into five portfolios, we will have 108 companies in each of the five portfolios. Decile 1 has companies where prices are in the range of Rs 1,790 to Rs 65,976 whereas in Decile 5 we have stocks in the price range of Rs 1.85 to Rs 38, which essentially means penny stocks.

The average returns of penny stocks as enumerated in Decile 5 are higher than other portfolios for the year 2020. Please remember that these are returns from price appreciation only and dividend has not been considered in this study. So, investing in penny stocks in 2020 would have generated a return of 69 per cent, which is much higher as compared to returns generated in any other decile. Nifty 50 returns are not even half of returns generated by the penny stocks’ portfolio. Further, if we look at average returns across the years, penny stocks have generated highest returns on nine occasions out of 11; this means a huge success rate. However, talking about returns without considering the risk factor is not a meaningful exercise. We all know that higher the risk, higher is the possibility of earning better returns. Hence, we calculated standard deviation of these returns to understand the volatility of the returns in each of the portfolio, as highlighted in the second table.

We observe that standard deviation of the portfolio of penny stocks in Decile 5 is highest across all the years. If we look at the average returns of portfolio formed in 2020 which was 69 per cent, this comes with a risk of 0.81 or 81 per cent. Standard deviation measures the amount that the returns deviate from its mean. 

For retail investors this indicates that if they select a few stocks from Decile 5 instead of investing in all the stocks, there are chances that they may go horribly wrong. We observe that the standard deviation of large-cap stocks is very low as compared to penny stocks across all the years. Retail investors should always take calculated risks after thoroughly carrying out their risk profiling and should not get carried away. Many companies in the penny stock category might face liquidity and survival issues based on the economic cycles. Hence, it is always advisable to exercise utmost caution and take professional guidance from a registered investment advisor before investing.

Dr. Ruzbeh Bodhanwala and Dr. Shernaz Bodhanwala, faculty at FLAME University, Pune