Lessons From The Penny Stock Crash

 

It has been two months since the penny stock crash. Still, the market is reeling from the repercussions. This issue, Shares Investment looks into the potential red flags that could prompt second looks as well as ways to avoid getting oneself into a sticky situation.

From being termed laggards to being the stock market losers of the year. All in less than a year. That was how quick the tide had turned for penny stocks listed on the Singapore Exchange (SGX).

Top Gainers

The mood was totally different at the start of the year. Trading activity was centered on smaller cap issues. It goes without saying that the other factor behind private investors? interest was the significant price appreciation.

But as the saying goes, all good things must come to an end. As penny stock trading continued to scale new heights, concerns began to set in. Subsequently, fences were established by trading firms to limit their exposures to the small cap section as early as March. Things then started to fall apart in October.

Two Months Back
On the morning of 4 October, shares of Asiasons Capital, Blumont Group and LionGold Corporation suffered heavy sell-downs. Within an hour of the start of the trading day, SGX placed these three counters, which already lost about 50 percent of their values, on suspension. Prior to this bloody episode, the equities market regulator queried Asiasons and Blumont on two occasions about irregularities in trading activities while LionGold received one query.

While these shares were back on the market the following trading day, they were tagged as designated securities by SGX. That did not help to break the falls. Market value of $3 billion was further wiped out in the next two days when trading resumed.



The massive plunge had a spillover effect on other penny stocks as well. WE Holdings, Innopac Holdings, ISDN Holdings and Mirach Energy, just to name a few, were among those affected.

 

Potential Red Flags
So are there signals that could help identify if one is getting into a sticky situation or is already in one? The answer to that is yes there are some warning signs an investor can make use of to detect if something is amiss. While one cannot deny that when things are set in motion, it might be tough to stop, it is handy for investors to get familiar with the early signals, albeit fuzzy at first, which may present themselves.

1. Excessive Price Action
Investors should be wary of stocks that have climbed or plunged multiple folds within short time frames because while it may be a market phenomenon, it could also be individual out-of-norm behaviours that warrant a second look.

It is absolutely normal to be tempted to gravitate towards what others are investing in. However, it is important that investors justify if this herding instinct that is causing rallies or sell-offs are backed by substantiated fundamental evidence.

2. Trading Restrictions
If brokerage firms begins to put trading restrictions on certain stocks, investors should also be vigilant to pick up that there may be unusual trading for such stocks. If the brokerage firms are protecting themselves by limiting their clients? exposure to the stocks, you should probably think twice as well.

3. Business And Management Changes
Staying up-to-date with your investments is essential as changes in the market environment could trigger or cause a change in the fate of the company?s health.

On an international level, economic downturns in major countries such as the US, China and Europe would have spillover effects onto the sentiment of the stock markets worldwide. Within the industry, developments such as the appearance of strong competitors and shifts in buyers? habits could disrupt demand and supply dynamics in the sector. All these exert pressure on the company?s performance, hence, it is important that investors are sensitive to the changing market trends and note how it could impact their interests.

Most importantly, on a company level, investors should look out for dramatic changes in company?s strategies, whether they are planning to switch its business, foray into new industries or sell its business entirely. For example, when the company starts cutting prices, selling off core assets or show a deterioration in quality of products or services, it could be a sign that that the company is in trouble.

One should also be concerned if major shareholders begin offloading a substantial portion of their stakeholdings in the market out of the blue. The sudden departure of key executives or board directors could also signal bad news especially when the individual concerned has a reputation for being successful or as a strong, independent director.

4. SGX Queries
SGX makes queries when shares of companies experienced unusual trading activities such as sudden price swings and questions the transparency of the company disclosures. Interested buyers or shareholders of stocks that have been put under query or multiple queries should exercise caution in such situations as there could be market manipulation or an over- or under-reaction to the corporate developments in the company.

New Mechanism
Another move targeted to offer protection is the circuit-breaker mechanism that SGX proposed to bring into its armoury in June. The addition is reportedly said to come online early next year.



While there are no hard and fast rules about circuit breakers, now might very well be an appropriate time for exploration. After sieving through the different types of circuit breakers deployed by exchanges around the world, below are some further considerations that may improve efficiency.

1. Define price bands based on sector
2. Cancellation of trades executed beyond price bands during cooling-off periods
3. Varying cooling periods depending on a set of defined price bands

Selecting The Right Stock
Nonetheless, no matter what new regulations are meted out by the exchange, the onus is not just on the regulatory authorities. Investors themselves have to play their own part in safeguarding their own interests.

For investors, a good rule of thumb is to adopt a selective approach instead of chasing a trend. One should be familiar with the industry or the company that you wish to invest in simply because it will help in better understanding the workings of the company and what drives its growth.

Some factors to consider when selecting a stock to invest:

1. Financial Health
What you should look out for is a consistent growth in revenues and profits over a number of years. This shows that the company has a growing income while an increasing profit suggests that it has expanding margins or strong cost controls.

Investors should be careful when the company?s assets are difficult to value and tough to estimate and also identify if any drastic jumps or falls are one-off or recurring incidents.

The cash flow position is also important as you can find out if the company has the financial flexibility to take advantage of any business opportunities or if it is laden in debt and may require more bank borrowings, which will incur additional interest costs, or equity funding, which will lead to dilution.

Most importantly, look out for a dividend payout as it is a sign of good financial health, especially if the company has been paying an increasing dividend or a stable dividend yield. This also gives investors a cash return on top of the potential capital appreciation of the stock.

2. Valuation
Common valuation metrics can be employed by investors to help gauge if a stock is indeed worth buying. Some of the common ones are the price-to-earnings ratio, price-to-book ratio and discount to book value.

However, investors have to bear in mind that these metrics are not ?one-size-fit-all?. Companies that are different in size, industry or at different stages in their market cycle will have different standards. Hence, understanding what is the average for the industry and the company is important and would help the investors sift out value buys.

3. Growth Prospects
Other than numbers, investors should also take a macro perspective on the industry and company outlook. How will the business evolve in the time horizon you wish to invest? Knowing how the company?s growth strategies and expansion plans fit into the global outlook of the industry would also help the investor identify if the company?s growth plans are intact.

Keep in mind that when you buy a stock, you are becoming a part owner of that company and the value of your investment will depend on the health of the business.