How To Choose A Penny Stock?

The answers to these 5 questions will help you understand whether a penny stock is investable or not:

A. Why is the company making losses? Is it generating positive operating cash flows?

B. How is its management quality?

C. Is the management changing hands?

D. Does it have a workable business model?

A. Why Is the Company Making Losses?

A penny stock can run into losses for a variety of reasons, some of which are:

1. Depreciation, a non-cash charge, may be eating into its profits
2. The company may have obtained debt that it can no longer service
3. Its business model may be outdated or prone to intense competition
4. The company is not efficiently managed

1. Depreciation

Some companies need to invest in a whole lot of high-value fixed assets to run their businesses. For example, wind power companies like Suzlon and Orient Green Power need to invest 100s of crores in machinery to set up an electricity-generating business that will pay them back over the long term. Likewise, companies like Zomato and PB Fintech have to pour 100s of crores in intangible assets (software development, apps, acquisitions) today so that they can generate profits after some years. 

Companies that invest huge sums into fixed assets need to provide depreciation, which erodes their profitability and lands them in losses. Such non-cash losses can make investors lose interest in the stock (which is what the stock goes on to become a penny stock). 

Take this example of Reliance Power, which generated Rs 3,600 crores worth of operating cash in the year ended March 2022 but ended up reporting a net loss of Rs 901 crores. The depreciation in the said year was Rs 1077 crores, which implies that the company did not incur a cash loss. Notice how the company used its operating cash flows to repay Rs 3,850 crores of its huge debt:

Also notice from the screengrab above that Rpower has been generating positive operating cash flows since 2016 which it has used to repay its debt.

The point is that penny stock companies that are generating healthy operating cash flows and using such cash flows to repay their debt can be definitely considered for investment so long as their business model is sustainable. 

2. Unserviceable Debt

Companies that do not generate adequate operating cash flows to repay their debt are likely to head to insolvency and should not be considered investable by serious investors. Out here, take the example of Vodafone Idea:

In Q2 2023, Vodafone Idea generated an EBITDA of Rs 4,098 crores but its interest obligation was Rs 6,033 crores. The company cannot even service its interest, so let’s forget about repayment of its humongous debt of Rs 2.38 lakh crores. Such penny stocks can be avoided by serious investors as they are mostly driven by news or operator activity. Of course, if there is a wholesale change of fortune in such companies, they can be looked at. 

3. Outdated or Loss-Making Business Model

Whether a business model is outdated or loss-making or not depends on your business analysis skills. For example:

• Penny stock NBFCs in an era of rising interest rates 
• Penny companies that rely on imports (when the $ is rising)
• Penny companies that make plastics at a time when single-use plastics are being phased out
• Penny stocks that make losses because their products don’t sell, maybe because the competition has rendered them inefficient

And so on. Serious investors should avoid such companies.

4. Inefficient Management

An inefficiently-managed company is one that lands up in losses and becomes a penny stock because its directors are not bothered about corporate governance or best practices in running an organization. Such companies may frequently be suspended from the stock exchanges or incur expenses that are not proportionate to their revenues, take on excessive debt, manipulate the stock price, or generally do acts that are not shareholder-friendly. 

B. How is the Penny Stock’s Management Quality?

Use this checklist to analyze management quality:

1. Google Directors’ Names

Assume the name of a director is “ABC.”

Search for the following on Google.

“ABC” + scam

“ABC” + politics

“ABC” + court case

“ABC” + cheating

plus, search “ABC” on Google News.

You can use other keywords as well.

Perform this search for all directors. If there’s any negative news for any person on the board, Google will dig it out.

2. Check Related Party Transactions

Penny stock companies set up a maze of subsidiaries and associated companies with whom they carry out sale and purchase transactions. The majority of sales and purchases of such companies may even be from their subsidiaries, sister companies, or associated concerns.

Look for the following while analyzing companies with a lot of related party transactions:

a. Sales and purchases to/from such companies (are these substantial or even significant when compared to the full year’s figures?)

b. Rents or consultancy charges paid to the promoter. (are these charges being paid despite the company making losses? or how much % of profits are eaten away by such transactions).

c. What is the salary paid to promoters and directors? How much is it eroding the profits by? Is the company paying huge salaries while being in losses?

d. Large chunks of bad debts that are written off almost every year. 

This information is contained in the Directors’ Report section of the Annual Report.

3. Solo or Unqualified Promoter

Check if:

a. The promoter is a solo act and is surrounded by close relatives and independent directors.

b. Are the directors qualified to run the business in terms of knowledge and experience?

4. Independent Auditor’s Qualifications

The independent auditor’s report will help you understand if the management has performed acts that are not in the interests of the company. Some examples: giving reckless guarantees on behalf of subsidiaries, not valuing closing stock as per accounting standards, not providing for interest, records destroyed in a fire or lost, etc.

C. Is the management changing hands?

Sometimes a debt-laden, inefficiently managed, or down-in-the-dumps penny stock company may just throw up its hands and allow itself to be taken over. Such penny stocks can be considered as investable so long their current market price is close to the price offered by the company that’s taking over. See what happened with Sintex and Alok Industries shares when it was announced that Reliance was in the fray to buy them.

Also, if the company is being taken over because it cannot repay its debts, then chances are that the new management will substantially reduce its capital, much to the displeasure of its shareholders.

In any case, such penny stocks can be considered as a long-term investment so long their debt is not unmanageable.

D. Does it have a workable business model?

Human beings evolve, and their evolution has picked up pace after COVID-19. For example, consumption of fossil fuels is all set to decrease as EVs gather pace, single-use plastics are all set to be banned all over the world, commercial property demand could reduce because work-from-home and flexi work hours have become the norm, and so on. 

So, you have to judge whether the company’s business model has what it takes to evolve with the times, and whether the management is savvy enough to change with the times.

If a penny stock has a workable business model operated by a non-controversial and qualified management, and it fulfills many of the positive conditions mentioned above, then you can certainly consider investing in it.

Summing Up

Consider investing in penny stocks that:

Have a decent business model but are running into losses because of depreciation

Have a futuristic business model, are fairly valued, have adequate cash, but are running into losses because their product or prototype will take some years to mature (pharma, software apps, etc.)

Are being taken over (so long their debt is manageable)

Have a sustainable business model (and fulfill most of the positive conditions described in the post)

Avoid Penny Stocks that:

Cannot service their debt

Have an outdated or huge-loss-making business model

Inefficiently-managed companies

Have poor management quality