Penny Stock Master Series - 1: The Quest for 10X Profits in 10 Years

Coming Monday, we are going to lift the curtains on a project that's very close to my heart.

Called the '10X Project', it's my blueprint for multiplying your money by 10X in penny stocks.

These stocks are, at the same time, the most profitable and most feared segment of the stock market.

Now, most people refuse to put in their hard earned money into penny stocks. They consider them as highly speculative.

Even if they do buy them, their exposure is usually so small that it hardly makes a difference to their overall returns.

Besides, their approach is also way off the mark.

They invest in every penny stock with the intention of finding the next 100-bagger. They have no game plan to invest in this highly lucrative segment of the market.

The result?

They incur huge losses and end up disillusioned with the whole idea of investing in penny stocks.

I strongly believe my web summit on Monday will force you to take a look at penny stocks in a totally different light. It will open your eyes to a huge opportunity, provided you approach it the right way.

That brings me to this master series...

My goal is very simple. I am putting my penny stock blueprint to test by evaluating its performance over a decade.

So imagine you are currently in the year 2011 and you have access to my penny stock blueprint.

Let's say you like the simple yet powerful techniques in the blueprint. You decide to have a go at penny stocks and invest Rs 10 lakhs into the strategy.

Well, that's big money even by today's standards. Therefore, I have a big responsibility on my shoulders. My penny stock blueprint better be very good!

By how much do you think this Rs 10 lakhs would have grown over the next 10 years?

Is the number significantly better than the benchmark indices? How many penny stocks do we need to invest in? What is the average holding period?

BREAKING: India's Top Trader Reveals #1 Investment of the Decade

Well, let's tackle these questions one by one.

In the first part of the master series today, let us evaluate the performance of the strategy in the first half of the decade i.e. between 2011 and 2015.

This period wasn't good for the Indian stock market. Fair to say that it was a wash-out.

The Sensex return was 5% per annum. This was much lower than the 14%-15% on a historical basis. One big reason the returns were poor was valuations.

The Sensex started this five year period at a price to earnings multiple of almost 24x. This was more than 30% higher than its long term average of around 18x.

The Sensex companies also found it hard to grow their earnings during this period. They plodded along at a poor CAGR of 9%.

Thus, there was a combination of high starting valuations and below average growth in corporate profits.

And so, we saw the Sensex give mediocre returns during this five year period.

But there was good news in store for my penny stock portfolio.

My penny stock portfolio went up 4.2 times in this five year period.

Yes, you read that right.

In a period where the Sensex struggled to beat even the fixed deposit returns, the penny stock portfolio amassed an eye-popping 33% CAGR.

How on earth could we have managed to pull this off?

Well, it's all because of the wonderful blueprint that aims to maximise profits and minimise losses.

You see, for me penny stocks are not the ones that trade at Re 1, Rs 2 or even Rs 20 per share. I believe most companies trading at this price point are poor quality companies.

As we want to invest in high quality penny stocks, our definition of a penny stock is a stock that trades at Rs 99 per share or lower.

Secondly, penny stocks are notoriously illiquid.

To deal with this problem, I insist a stock will enter the portfolio only if it has an average trailing twelve month liquidity of Rs 5 lakh or higher.

I know this is still low but considering that our universe is penny stocks, it's an appropriate number.

Now, here comes the most important part. One of the biggest myths surrounding penny stocks is that if your stock selection is right, you can make good money all the time.

Nothing could be further from the truth. Penny stocks are infamously volatile. Put differently, in a bull market, penny stocks will rise faster than their peers and in a bear market they fall faster.

In fact, penny stocks can give up, in just a few trading sessions, all the gains of a few years.

So here's what we did...

We never invested 100% of the portfolio i.e. the Rs 10 lakh, in penny stocks. There was at least 25% set aside to be invested in fixed deposits. This would earn about 7%-8% per annum.

We allocated the remaining 75% depending on the valuations of the broader market.

Thus, if the stock market looked expensive to us, we allocated only 25% to penny stocks and had as much as 75% in fixed deposits.

And if it looked cheap, we allocated 75% to penny stocks and the rest in fixed deposits.

We did this rebalancing once every year. At the end of a year, we would have a look at the market valuations and decide our allocation accordingly.

Luckily, during the first five year period, the markets were never prohibitively expensive. So our allocation to penny stocks stayed at the maximum 75% for all the five years.

Now let me share with you the kind of penny stocks that made the cut...

Let me put it this way. They were fundamentally strong penny stocks with a big fat margin of safety in valuations.

When it comes to value investing, you should ideally look to buy a Rs 100 note for Rs 80 or lower. For penny stocks, your margin of safety needs to go up further. Something like a Rs 100 note for Rs 50 or lower.

No penny stock entered the portfolio if its trailing twelve month PE ratio was higher than 8x.

I only considered those penny stocks that were very attractively valued i.e. a price to earnings multiple of between 3x and 8x.

Also, their balance sheets had to have at least 50% of the assets funded by net worth.

The first condition ensured that only the most attractively valued penny stocks filtered through. This set the upside to downside ratio in our favour.

You see, a good quality large cap is usually bought at a price to earnings multiple of around 16x-18x. However, we are dealing with penny stocks here. They carry more risk of a permanent loss of capital.

Thus you should look for penny stocks which are at least twice as attractive, if not more, in terms of valuations.

And our condition of a price to earnings multiple of maximum 8x does just that.

The second condition ensured that the penny stock had the balance sheet to survive tough times and come out unscathed at the other end.

A balance sheet that's funded more by net worth and less by other liabilities is a sign of a strong business.

This is exactly the quality we want in our penny stocks.

So, these two criteria would lead to a very attractive portfolio. However, I have thrown in a few additional criteria like a minimum revenue size, dividend history etc, to try and get the odds even more in our favour.

I will discuss the entire blueprint and this additional criteria in detail in my webinar on Monday. So do keep an eye out for it.

For the time being though, let's get back to how we managed to achieve more than 4x returns from the penny stock portfolio in the first five year period.

Another very important rule for investing in penny stocks that does not get the attention it deserves is the selling aspect.

As highlighted earlier, if you fail to exit a penny stock at the right time, you may end up giving back all the gains.

Thus, having a good selling rule is very important.

I have tried to keep it pretty simple here. The rule says the stock stays in the portfolio for a period of one year.

At the end of the one year period, it's sold and irrespective of whether it has gone up or not.

This rule has two fold advantage. It ensures that we keep booking profits on a regular basis. It also ensures laggards don't stay in the portfolio for long and spoil the returns.

As I have often said before, the best rule for selling a stock is the one that's simple and is pre-determined.

So here's the recap of the major elements of my penny stock blueprint.

• A yearly rebalancing rule. When stock market are cheap, 75% money to be allocated to penny stocks and 25% to fixed deposits. The reverse when markets are expensive.
• A portfolio of 20 penny stocks, equal weighted, where the major conditions are the PE ratio rule and the net worth to total assets rule.
• All the stocks are sold at the end of the one year period irrespective of whether they are up or down. A new portfolio is then created based on the broader allocation.

The portfolio had only one down year i.e. 2011 where it suffered a 13% decline. It gave positive returns in all the other years.

Returns for 2012, 2013, 2014 and 2015 were 32%, 17%, an impressive 88% and 67% respectively.

And here are the penny stocks that were the top performers during this five year period.

• Atul Auto 142% in 2012
• Expleo Solutions 191% in 2013
• D-Link India 481% in 2014
• Orbit Exports 288% in 2014
• GM Breweries 780% in 2015

These are all solid returns and a big reason why the portfolio did so well between 2011 and 2015.

Now are you thinking how we managed to have such great returns with such simple rules when the smartest minds on Dalal Street fail to even beat the indices?

Well, here's Ben Graham from an interview back in 1976.

• I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.

Well, the right general principles is what we have. We are determined to stick to them come what may.

So, do join me for my summit on Monday to learn more about the simple principles and techniques and how we can beat the hell out Dalal Street.

But before that, our performance during the second half of the decade...

Will the period between 2016 and 2020 turn out to be as rewarding as the first five year period? Will the portfolio go up another 4x or will it encounter some serious roadblocks?

Well, let's find out tomorrow.

Goodbye and take care.

Good Investing,


Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)