Build a diversified penny portfolio

Penny stocks hold special lure for investors. Their acquisition cost is cheap, in low single digits, and the upside potential is almost limitless. A mere couple of rupees or, in some cases, a few paisa rise in the stock price would double or triple your initial capital.

On the flip side, purists and market pundits look down upon investments in penny stocks. And they have valid reasons to be skeptical about penny investing. Most penny stocks are little-known companies with a poor track record of financial performance.

Their business plans cannot be trusted or bought at face value, either. These companies can easily go into oblivion without any trace. This makes penny stocks risky bets in any market situation. You may make millions or end up forfeiting your entire capital.

But optimists consider risk as the other side of return. Greater the risk, larger is the reward. Does penny investing work or is it equivalent to being penny-wise and poundfoolish. We at ET Intelligence Group (ETIG) decided to dig into historical data to see whether it worked in the recent bullrun.

And the evidence suggests that penny stock investing not only worked, but provided much superior returns than the frontline counterparts constituting the benchmark indices.

The returns on penny stocks, however, depend on the extent of diversification. This segment has a high mortality rate and the only way to reduce stock-specific risk is to start with a larger portfolio.

Statistics have proved that incremental risks decline significantly if the sample size is more than 30. We have analyzed around 90 penny stocks. One can opt for a greater or lesser number of stocks, depending on the risk appetite. Since the future potential is unknown, one can choose to buy an equal number of each stock.

With the passage of time, many stocks would turn to zero and some might not move at all. But if history is an indicator, this portfolio would definitely provide superior returns after 6-10 years compared to the overall market. One should bear in mind that this is a longterm strategy and one shouldn’t be worried about intermittent market movements.

If one had invested in a portfolio consisting of around 100 penny stocks way back in 2001, one would have made total returns of about 1500% by the beginning of March this year.

These returns are calculated at prevailing prices and would have been much higher if one had exited the portfolio when the market was at its peak last year. We did a quick check to find out how this portfolio has performed against others.

The penny stock portfolio has outperformed two other portfolios consisting of stocks in the Rs 1-10 and Rs 10-100 price ranges. These two portfolios, which are equally diversified, have given price-weighted returns of around 530% and 240% respectively.

Price weighted return is the total returns generated during a time period if one had purchased one share of each of the stocks included in the portfolio. The result is similar if one considered equal weighted returns, whereby an equal amount of money (say Rs 100 each) is invested in each stock. The portfolio has even outperformed the Sensex and Nifty.

Although the portfolio will have some losers, whose value might have become zero, the few stocks that eventually turn into multi baggers will significantly offset such losses and give superior returns.

For instance, stocks such as Sawaca Communication, Ispat Profiles and Alps BPO lost their entire value.

However, these losses in the portfolio were more than offset by multi-baggers like Unitech, Gujarat NRE Coke, Mercator Lines, Texmaco, Geojit Financial Services and National Mining Development Corporation (NMDC). The stock price of most of these stocks rose 100-160 times.

Investors do not have to incur huge initial investment costs as most penny stocks are available at throwaway prices. One could have made a price weighted portfolio of these 90 stocks with as little as Rs 55 in 2001. Small investors can construct a diversified portfolio at a minimal investment and benefit from superior returns.

For this analysis, we have considered stocks at three different price levels, below one rupee, above one rupee and less than ten rupees and stock prices above ten rupees and below hundred rupees, during the last downturn in 2001. Though we have focused more on the sub-one rupee stock portfolio, investors might consider other portfolios where the stock prices are close to this range.

Further, we constructed three portfolios and found out the total returns, both price weighted and equal weighted, in the past eight years.

To compare these returns with the benchmark indices, we considered the Sensex and Nifty in 2001 and calculated the price-weighted and equal-weighted return assuming that composition of these indices has not changed. Finally, we made a comparison among these portfolios and with the indices.

The purpose of this analysis is to make the retail investor aware of different investment opportunities during a downturn. Past returns are only an indication and might not warrant similar returns in the future.

However, such a portfolio could outperform others and a smart investor with the ability to cherry pick individual multi-baggers can even beat this penny stock portfolio in the next bull-run.