Penny stocks are bad for your investment health.
There is a great temptation to try to make a quick buck. The truth is that the chances of making an overnight fortune from tuppence in the stock market are as slim as in the casino or Lotto, or a golfing hole-in-one!
I am a strong supporter of investing in the equity market for the long term. You all know the story of acorns growing into huge oak trees that provide shade and protection. We should all aspire to retire with a lovely oak tree as our financial underpin.
There is often a temptation for investors to look over their shoulders on hearing of rags-to-riches stories of stock market miracles from penny stocks. I am the arch penny stock sceptic. I like to invest in businesses that I can easily understand, that have a long track record of growing dividends, and that provide goods and services that you know are required.
One of the fundamental problems with so-called penny stocks is the fact that speculators (let's call them investors) think they are cheap because they trade at less than a rand, and often at only a few cents. The rationale goes that it is far easier for a cheap share to rise by a great multiple than it is for an expensive one. This notion is completely devoid of logic. Shares are priced by the market in terms of information in the public domain about the prospects and results of companies.
There is usually a very good reason that a company's shares are awarded penny stock status. It can be the fall from grace of a once sound and profitable business or it can be an opportunistic listing at the top of the market, but most often it is the result of an unviable company going public with fantastic promises. A very important part of a vibrant stock exchange is the ability of companies to list and raise capital. There is also a clear role for venture and development capital listings, but they come with a health warning and are only for investors with a high risk tolerance who can easily afford huge capital losses.
A study of penny stocks over the years reveals a number of common denominators. The most alarming one is the consistently late production of annual reports, which are typically remarkably sparing with the type of detailed financial information that is required to do proper analysis. Explanations for disastrous results are not forthcoming, but promises of better things to come are highlighted.
If you feel compelled to invest in this category of share, you really need to do your homework. If you cannot find enough information, avoid the company. Read all the available information published in the press, via the Stock Exchange News Service and by the company (annual reports and the like). You need to understand the nature of the business and come to a clear belief that there is indeed hidden potential.
You need to look at the trading history of the share. Do enough shares trade so that you can build up a decent holding without pushing up the price? Do the directors hold sizeable positions and have they been buying or selling? Look at the shareholder list to see if there are institutions involved or prominent investors who might instill some confidence.
I can make no case for investing in penny stocks, but if you must, make it a separate portfolio; do not over-diversify; bank your profits (in the unlikely event that you make any); and do not be afraid to sell at a loss if things do not go the way you envisaged.
My strong inclination is to protect investors from their own stupidity (greed, ignorance, naivety - call it what you will) by removing the temptation. The simplest way would be for the stock exchange to introduce a rule that when a share's price falls below a rand and remains below that level for a calendar month, an automatic consolidation takes place that is well publicised to the investing public. (When a company consolidates its share capital, it decreases the number of shares in issue by a certain percentage. The price, in theory, increases in proportion to the decrease in shares. In a one-for-10 consolidation of a share trading at 20 cents, a shareholder who had 100 old shares would have 10 new ones after the consolidation, and the price would increase from 20 cents to R2.)
Through share consolidation, many companies would eventually be consolidated out of existence very publicly rather than just disappearing from the board quietly and never being heard of again.
I have a cabinet drawer bursting with the valueless share certificates of penny stocks that crashed and burned without trace. In the dematerialised world of today, you will not even have the luxury of a share certificate to remind you of the lessons. Avoid penny stocks unless you are very rich and have cash to burn. A useful charity could be a better alternative.
- David Sylvester is the chairman of the Shareholders' Association, telephone 021 686 7567.