InvestorQ : Are there are any signals that a particular stock could end up as a penny stock in future?
ishika Banerjee made post

Are there are any signals that a particular stock could end up as a penny stock in future?

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2 years ago

Financials may be much maligned but they rarely narrate the wrong story. If you scratch the surface and look a little deeper into financials, you get to see the truth gradually emerging. Check the financials of the company. Do you see signs of deterioration? Do you see a consistent fall in profits or narrowing of margins? You must get worried if the company is consistently underperforming its peer group. Look out for risk factors like a high debt/equity ratio, too much of short term debt, delay in payment to creditors, default in loan instalments etc. Check if the sales of the company are plummeting too rapidly. More often than not it is a case of the industry changing too fast and the company not keeping pace with it. There are also cases where the company takes some lousy decisions and that is visible either in the income statement or in the balance sheet. Quite often, the problem areas are also visible in the cash flow statement.

Every business operates in a particular environment and needs to quickly and effectively adapt to the environment. Try to understand if the operating environment is changing. You need to be careful of companies that are not able to adapt to the big changes happening in the industry. Nokia is a classic example. Indian PSU banks, telecom companies like MTNL are all classic examples of becoming worthless stocks purely because they did not see the larger trend in the industry. Take the case of how Kingfisher lost out to more agile players like Indigo and Spice Jet that managed to discover a profitable way of running the aviation business. Take the IT industry today. You must be cautious of companies that are not able to adjust to the new digital environment. Similarly, banks and financials that cannot effectively use technology to reduce costs will also destroy value for shareholders. As disruption gathers pace and momentum, you will find more industries getting disrupted in more number of ways than ever before.

Keep an eye on the exits from the stock. This is a classic give away for the stock. Are the promoters and informed investor gradually exiting the stock? We saw that happen in case of Himachal Futuristic and even in case of Satyam where the promoters and the institutional investors were gradually exiting the company when most of the retail investors were left holding on to worthless paper. These indications are there long before the crisis strikes.

Spend considerable time checking the background of the promoters. That is the make or break for the company. What is the background of promoters of the company? Today the background of promoters is available with the MCA and you can easily access the same. It will give you a good idea as to what has been their experience with other projects. Some promoters are habitual offenders and as an investor you need to be doubly careful of them.

They say there is no smoke with fire and so watch out for the small fires that can blow up quite fast. Manpasand began with a small audit resignation and the game gradually unfolded. You start seeing a series of negative reports of the company in the press, in discussion forums and in analyst notes. One sign is the number of positive analyst recommendations reducing. Also check if the debt paper of the company is consistently getting downgrade. In case of companies like Amtek Auto it all began with the downgrade of its debt paper and then the entire crisis snowballed. You surely do not want to end up holding on to such worthless paper.

They call it restructuring but you either see mass retrenchments or mass resignations. There is something rotten in the company then. Nobody leaves a normally functioning company in droves. You see signs of large scale downsizing of operations. This could be in the form of reduction of employees or in the form of downsizing of volume and spread of operations. Some amount of right-sizing is part of the game but large scale downsizing is not a good sign. Also be careful if the net external debt of the company is substantially more than the market cap. Such companies are classic recipes for disaster. You will find the standard irritants like delay in salaries, defaults in small inter corporate loans, defaults in payment of taxes on time, PF delays etc. All these are warning signals.