Penny Stocks May Be Pound Foolish
July 14, 2003
By MATTHEW LUBANKO, Courant Staff Writer
There is an eerie feeling that we've seen this scary movie before.
Investors are speculating again.
While they're buying stocks of every size and shape, they've developed an especially ravenous appetite for so-called "penny stocks."
These are the companies whose shares are priced below $10, companies that often are losing money and deeply in debt. They also, quite frequently, are companies whose names were once synonymous with rapid growth.
The low-priced stock winners with strong Connecticut ties includes TranSwitch Corp., Royal Ahold (parent of Stop & Shop) and Vion Pharmaceuticals. Lady Luck also has kissed Dynegy, Corning, Calpine, and AMR Corp., the parent of American Airlines.
These and other low-priced stocks have doubled, tripled, even sextupled in recent months.
Shares of Vion have risen from 30 cents to $1.82 since late March. (Figures are as of Friday's close.) Royal Ahold has soared from a mid-March low of $2.95 to $8.43. And TranSwitch Corp. stock, after dipping to 48 cents a share in February, has climbed to $1.70 as of Friday. Each company is operating in the red.
This swift and breathtaking success of money-losing companies has left some money managers wondering if investors - large and small - are ripe for a whipping again.
"Only a fool would buy these things in the first place. And only a greater fool would pay the inflated prices for companies that aren't making money - and have little or no chance of making money by the end of the year," said Scott Black, president of Delphi Management Inc., a money management firm in Wellesley, Mass.
Managers such as Black do not want to sound like killjoys. Rising stock prices have revived many fortunes. They have helped to boost consumer confidence. They have reignited the flamed-out ratings at the all-business news channel CNBC. They have rekindled the market for corporate mergers and new public companies. They also have made work a lot more fun for money managers whose spirits desperately needed a lift after severe stock market losses in 2000, 2001 and 2002.
The Risk Factor
But the rally in penny stocks has elicited some uneasy feelings of deja vu. This stock market success has attracted more cash, which ends up pushing share prices even higher. Eventually there could come a point - as it so began in late March 2000 - when investors start to wonder if the mania for money-losing companies makes any sense.
Along with no profits, many of these penny-stock companies - especially Calpine and AMR - carry heavy loads of debt. Many also have risen on expectations that the economy will improve dramatically, even though the economy is a mixed bag at the moment. A few have risen so fast because of a sophisticated trading technique that may have run its course. And, perhaps, a few have risen because investors - like gamblers during a bad night at the racetrack - are wagering on long shots with the faint hope of winning back what they've previously lost.
"There could be an element of `getting-evenitis' at work here," said Bernard Murstein, a former professor of psychology at Connecticut College in New London and author of "Getting Psyched for Wall Street: A Rational Approach to an Irrational Market."
Many investors, Murstein said, have lost thousands or millions of dollars during the three-year bear market. "Getting-evenitis," Murstein said, impels some to take risks they previously might have avoided.
"They know they have lost money. They know they cannot quickly recoup those losses by investing in Gillette or Coca-Cola. So they invest, instead, in the cheap stocks with the hope that they might double or triple some of their money and perhaps ease the pain of the losses" they suffered from 2000 through 2002, Murstein said.
The risks are usually quite clear to anyone who buys a name-brand penny stock.
Royal Ahold, for example, has been accused of cooking its books and making its profits look fatter, prompting investigations by the U.S. Department of Justice and the Securities and Exchange Commission, as well as prosecutors in the Netherlands, where the company has its headquarters. Investigations revealed that the company overstated pretax profits by a combined $880 million in 2000, 2001 and 2002.
At TranSwitch in Shelton, the erosion of the global semiconductor market has depressed annual sales from a peak of $155 million in 2000 to $16.6 million in 2002. A key question today, analysts say, is whether the company will run out of cash - it had $175 million in cash as of late March - before it can turn a profit again.
And at Vion Pharmaceuticals, the story is similar to that of many biotechnology companies. The New Haven-based incubator's products have enjoyed some success in clinical trials. But, at this moment, it has no products on the market - and it might never have a drug or treatment it can sell.
Around the United States, other penny stocks have similar tales of woe. AMR Corp. reported a $3.5 billion loss in 2002, after losing $1.7 billion in 2001. Corning and Dynegy each lost more than $1 billion in 2002, after riding high in 2000 and 2001. Corning, in fact, traded above $100 a share in 2000 before tumbling to $1.10 a share in October 2002.
"If the economy doesn't deliver the goods, as many seem to think it will, a lot of these companies could be in the soup again," said Michael Flament, chief economist with Wright Investor's Service in Milford.
The Lure Of Selling Short
Yet excessive pessimism, not optimism, might have caused some penny stock shares to rise in the first place.
To see how pessimism can push certain share prices higher, one has to understand the mechanics of a short sale - essentially a bet that a stock will go down instead of up.
When money managers "sell a company short," they typically borrow shares in the underlying company with the agreement to buy back the shares they've borrowed at a later date.
When the bet works out as planned, the managers borrow high and buy low. The difference between the price at which they borrow the stock, and the lower price at which they later buy, is their profit. A loan of stock at $10 a share, followed by a purchase of that same stock at $5 a share, for example, results in a $5-a-share profit. If, however, the shares of the borrowed stock rise, investors are often forced to "cover" their short sale by going to the market and buying at a loss.
In most years, short sellers are merely a market sideshow. But in 2002 and early 2003, short sellers were hailed as budding geniuses because they were among the few money managers making money for their customers, said Jeffrey Saut, chief investment strategist at Raymond James Financial in St. Petersburg, Fla.
"Short selling and hedge funds [accounts managed for institutions and the wealthy] became the investment du jour," Saut said.
In March, about when stock prices hit their most recent bottom, short selling hit a peak. And many of the names on today's list of market winners - including Dynegy and Calpine - hit their "short interest" peak; that is, substantial portions of their shares were borrowed with plans to buy them back at a lower price.
But when the share prices rose, Saut said, the penny-stock shares were purchased to limit short selling losses - and not with the idea of profiting from a new bull market that began March 11.
Furthermore, since this wave of short-sale-related purchases has ended, it provided just a one-time kick for penny stocks.
If investors don't continue to see these stocks going north, they may start to sell. These stocks could later fall as quickly as they rose.
"This love affair with low-priced stocks is doomed, and the divorce could be really ugly," Saut said. There is just no tangible reason, he said, to suddenly love companies that seem destined to remain in dire straits for quite some time.
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