If you have been investing in the stock markets or looking to, you may have heard of the term penny stocks. As the name suggests, penny stocks are those that are traded at low prices. Also, penny stocks have low market capitalization and are often hard to spot.

Much like small caps, penny stocks, often called nano or micro-cap stocks, may not have a lot of information around them, unlike the case of large caps which are well-established big companies. In the US context, a stock is considered a penny stock if it trades below $5, and in some cases, even below $1. In India, it is largely considered a penny stock if it trades below Rs 10.

Penny stocks allow investors to make small investments and are affordable. However, as an investor, you would need to research the company, its fundamentals, growth prospects et al and the industry average, before picking a penny stock which may eventually turn into a multi-bagger penny stock.

What then are multi-bagger penny stocks?

Multi-bagger penny stocks are stocks whose prices increase many times since you first invested in them. Every ‘bag’ is representative of your first investment, so if you were to invest Rs 500 in XYZ stock and the holding of the said stock is worth Rs 1,000, it means ‘two bags’ or a two-bagger. Similarly, there could be a five-bagger, six-bagger, and a ten-bagger, and so on. The maths follows that a two-bagger reflects a 100 percent gain, a three-bagger reflects a 200 percent gain, and so on.

The term has a baseball reference, wherein players accumulate bags as they run around bases. This term has been drawn from the book, ‘One Up on Wall Street’ authored by Peter Lynch.

What are the characteristics of companies that go on to have multi-bagger penny stocks?

  • The penny stock that goes on to become a multi-bagger is not in the spotlight. But, this doesn’t mean that the fundamentals of the company are not good; in fact, it is quite the opposite. Penny stocks that go on to increase in value are those that have strong fundamentals and grow on the back of solid performance. The likelihood of finding penny stocks among small caps and mid-cap companies may be relatively higher, therefore many multi-bagger stocks are called small cap multi-bagger stocks.
  • An attribute of a multi-bagger is that such a stock belongs to a company that has clarity about the direction it wishes to take, has clear goals and objectives, good management, and leadership. This means that such a penny stock is not a flash in the pan, it grows over a period of time and becomes a multi-bagger.
  • Before picking a penny stock, it is important to examine why it is a penny stock in the first place. If the stock is undervalued and has good management and potential of the company, with high stakes of promoters involved, it is a penny stock that may have the potential of turning into a multi-bagger.
  • Checking the P/E ratio (price-to-earnings) ratio helps analyze if a penny stock is undervalued or overvalued. Sometimes, a stock may be overvalued as the company may not be performing well. The P/E ratio is arrived at by dividing the stock price by the earnings per share (EPS). A low P/E ratio means the stock is undervalued.
  • If you are exploring multi-bagger ideas, you would need to look at a company that may be at the early stages but is backed by a strong product or service. Such a product or service will carve a niche in the market.
  • Multi-bagger stocks come from companies that are backed by solid promoters who have stood by them, from the time of their inception till their growth. A promoter holding that is solid gives out the message that there is trust in the business.
  • A multi-bagger penny stock has a high earnings per share (EPS) growth. Monitoring a company’s EPS and checking the percentage of growth helps understand if the stock price can increase multiple times in the future.
  • One more way to look at multi-bagger ideas is to check a penny stock’s profit margins. A penny stock that has a greater margin of profits, both gross and net, than the average for the industry it is part of has the possibility of becoming a multi-bagger stock.
  • The level of debt for a company with a penny stock should be as minimal as it’s possible.
  • Look for a penny stock that has adequate free cash flow, ie, the cash that is remaining when the company uses capital expenditure from the cash flow. Such a stock has the potential to turn into a multi-bagger stock.
  • The industry or sector to which a penny stock belongs also holds relevance while exploring multi-bagger ideas. Some industries or sectors may be poised for greater growth than others, so keeping a lookout for such industries helps in identifying a potential multi-bagger stock. If an industry doesn’t show growth potential, it may be difficult for a company with a low market cap and penny stocks to turn into a high-performing one.

Avoid certain pitfalls of penny stocks such as these:

  • Mere affordability should not be a factor while opting for a small-cap multi-bagger penny stock. Ideally, an investor needs to have a budget in mind and plan accordingly.
  • Penny stocks are not liquid and you may find it relatively tougher to find a buyer.
  • There is not a high amount of information made available to the public when it comes to a small-cap multi-bagger; this means a lot of research is involved and a busy or a newbie investor may not have the means to do so.
  • Some penny stocks may find themselves under the scrutiny of the market regulator from time to time. They may also be delisted by the regulator for issues pertaining to non-compliance.
  • While penny stocks have the potential to turn multi-bagger stocks, they may also not reach that stage so it is important to choose after consideration.

Now that you know both the advantages and disadvantages of investing in penny stocks, the importance of staying disciplined and constantly monitoring stocks cannot be underlined enough.

In conclusion

Studying the fundamentals of a company to understand its earnings growth, debt level, and profit margin, apart from the composition of its management helps in identifying multi-bagger penny stocks. A high promoter stake in the business also shows that there is trust in the company’s performance, indicating that a penny stock is a potential multi-bagger stock.