How Low Is Too Low?
When a stock dips below $5 a share, investors may shy away from once sought-after companies. Gateway is one company that found it doesn't have to stay that way.
Kara Newman
December 11, 2003 | Thomson Financial
Wisdom holds that institutional investors, particularly mutual funds, automatically unload all holdings of stocks trading below $5 a share. As a result, finance executives may worry that wholesale institutional selling could put further pressure on a teetering share price. If a stock lingers too long at that level, sell-side analysts may drop their coverage, making it even harder bring a company to investors’ attention.
Although it’s true that many institutions will not hold stocks trading below $5 a share, this is not universal. Many investors regard a good-quality company trading at a low share price as a buying opportunity. For the company, the trick is to stay on the radar screen of the appropriate investors and to keep the communication flowing. This can be a rough task, of course, when staffing is tight and resources in the investor-relations department are already stretched to the limit.
Why Is the $5 Level Important?
Although it might seem arbitrary, investors consider the $5 level important for several very specific reasons:
Most initial listing requirements include a minimum bid of $5 a share. This applies to the Nasdaq National Market and the regional stock exchanges, though not to the New York Stock Exchange.
The official SEC definition of a “penny stock” is an equity trading for less than $5 a share that is not traded on the listed markets of the NYSE, Amex, or Nasdaq, but on the bulletin board or the pink sheets. Many — but certainly not all — of the companies listed on the OTCBB and pink sheets are not particularly transparent in their business and reporting practices, have a higher likelihood of filing for bankruptcy, or may otherwise be much riskier and less liquid than listed stocks. This is one reason that a NYSE or Nasdaq listing is prized — it’s considered by many investors to signify “legitimacy.”
It is more difficult to short stocks trading below $5 a share, since price is one of the factors the SEC uses to determine a stock’s riskiness. As a rule of thumb — though this is just one criterion — stocks trading below $5 are “not marginable” and therefore not eligible to borrow or sell short.
Typically, liquidity decreases and volatility increases for stocks trading under the $5-a-share threshold. However, this may be a self-fulfilling prophecy: if institutional investors won’t hold the stocks, liquidity would fall as a direct effect, and volatility would rise.
Many brokerages explicitly forbid (or at least strongly discourage) trading in speculative stocks, including penny stocks. Often customers must sign extra paperwork acknowledging that they are aware of the risks of buying these stocks. The NASD also has conduct rules specifying that recommendations to customers must be “suitable” for a customer. Therefore, for certain customers, deliberately buying or recommending speculative stocks would be considered irresponsible.
Mutual funds draft their own charters, and some choose to avoid stocks under $5 a share. However, they are not obligated to do so, except for fiduciary reasons. Many mutual funds specify that they will hold only stocks listed on the NYSE or the Nasdaq National Market. Furthermore, unless the fund explicitly specializes in small-cap/high-risk shares, holding penny stocks may be bad for business because they are perceived as an unwarranted financial risk for investors.
Communication Is Key
Poway, California-based computer technology company Gateway Inc. has traded on both sides of the $5-a-share marker during the past two years. While many companies cope with a sub-$5 situation by using reverse stock splits or share buybacks to help prop up a sagging share price, Marlys Johnson, who is in charge of investor relations for Gateway, notes the single most important action an investor-relations professional can take: “Communication, communication, communication.”
“Whether it’s cost-cutting scenarios, or new product introductions, or whatever good news you’ve got to tell, get out there and tell it,” explains Johnson. The more “good news” investors hear from investor relations, she says, the better you can counteract potentially poisonous negativity from short-sellers or hedge funds that can help depress the stock price further.
Gateway’s quest to maintain current shareholders while attracting new ones is complicated by the fact that the makeup of investors see-saws depending on the delicate balance of the share price. Value investors may pile into the stock when the price dips below $5, but when the price heads north again, many value investors bail out, putting their profits into another “value play” company. Meanwhile, growth investors will take over when the stock buoys higher, but may lose interest if the stock descends.
For this reason, Johnson encourages IR professionals to review their list of current shareholders and consider targeting new investors, and to tailor that list according to stock price and company strategy. “If you are below $5, maybe you should look at value investors, see if your company matches their criteria and target them. Then as you start to grow and get some traction, go to the GARP [“growth at a reasonable price”] and maybe the growth investors.”
Gateway also found unexpected dividends to trading below $5 a share: “Because our market cap went below the qualifications for the Russell 1000,” says Johnson, “we entered the Russell 2000,” an index closely followed by a number of active and index-oriented institutional investors. “So there was a little more liquidity in the stock, and that was basically because we traded below $5.” A lower price, she adds, also makes the stock more attractive to individual investors.
AI
