Reversal of Fortune

It wasn't that long ago when a client would suggest a $5 stock and a broker would shake his head in disbelief and reply, “Why would you want to take a chance on a penny stock?”

Today, chances are you'd recognize at least a few penny stocks. After all, some of them — Lucent, Corning, EMC, Nortel — were among the highest of fliers during the latest market mania. In fact, some still may be lurking in your clients' portfolios. That wouldn't be surprising. According to Morningstar, the percentage of stocks trading below $5 on the major U.S. exchanges has been creeping up, from 10.2 percent in September 1997 to 16.3 percent in September 1999 to more than 25 percent in September 2002. If your impulse to sell didn't drive you out of these companies before their stocks broached this undesirable threshold, what should you do now?

Take your lumps and sell, advises Bernie Schaeffer, chairman of Schaeffer's Investment Research in Cincinnati. Sure, he reckons, these low-priced issues can rocket — but they also can tank. “You are no longer an investor in growth stocks,” Schaeffer says. “You are instead speculating on the survivability of some very distressed companies. This means significant day-to-day volatility as well as some wipeouts. If this prospect drives you at last to sell, that's probably not a bad thing.”

The “never angels” in the sub-$5 range are even riskier. According to Thomson Financial Executive Vice President Evan Klein, such stocks “are often not particularly transparent in their business-reporting practices, have a higher likelihood of filing for bankruptcy, and may otherwise be much riskier and less liquid than listed stocks.” Klein points to studies which have shown that these equities experience increased volatility and decreased liquidity, largely due to a lack of institutional ownership.

Pension funds and other institutional investors often have rules that limit holdings of penny stocks. Most brokerages explicitly forbid, or at least strongly discourage, trading in such stocks. If trading is allowed, clients must sign paperwork acknowledging their awareness of the additional risks incurred by investing in sub-$5 shares. Mutual funds also often restrict themselves from investing in very low-priced stocks unless it's a low-priced, deep-value or small cap or micro cap fund.

Companies don't much care for penny-stock status either. Some attempt to boost their share price unilaterally through share buybacks or reverse splits. Neither act, however, has much lasting effect. Buybacks can take years to yield results and, generally, a company that has nothing better to do with its cash than buy back its own stock is not viewed as a great growth vehicle. A 10:1 reverse split, for example, magically transforms a 75 cent mutt into a semi-respectable-looking $7.50 hound. But only for a while.

Sean McGowan, director of research at New York brokerage firm Gerard Klauer Mattison, believes that such actions usually backfire. The price has the support of something like an air pocket that temporarily keeps a broken ship a¾oat. “Sometimes distressed stocks bottom around 50 cents, even when liabilities exceed assets, suggesting that shares are theoretically worthless,” says McGowan.

Do these penny-stock rules apply to the growing list of sub-$5 stocks that used to be called blue chips and major growth stocks? Most analysts, in fact, advise investors to stay away. Tom Barr, managing director of New York brokerage Munn Bernhard, says his firm doesn't bottom-fish. “Don't be fooled by former high-flying issues that have become penny stocks; that's what they are,” he says.

Morgan Stanley's chief technical strategist, Rick Bensignor, thinks the stigma traditionally attached to sub-$5 stocks continues today, despite the growth in their numbers and the inclusion of formerly high-flying companies. “The market is telling us something about these stocks, regardless of the reason,” explains Bensignor, “and I would generally avoid them.”

Stephen Saker, vice president at Florida-based International Assets Advisory, an independent financial advisory and brokerage, is equally skeptical about sub-$5 stocks. However, he believes that generalizing about these stocks today is slightly more difficult. “Just a few years ago, such companies would be regarded as small, risky ventures,” he says. “But now, the group includes companies that still have billions in sales and assets and tens of thousands of employees. Some may indeed go out of business, but others still have decent balance sheets and will survive.”

Assuming that the U.S. does not sink into a double-dip recession and that a moderate recovery in the global economy ensues, Saker thinks telecom-equipment provider Ericsson could triple over the next year. “Its $3 billion rights issue completed in September was a remarkable feat for a sub-$5 stock and tells me that the market still retains a significant degree of faith in Ericsson's recovery.”

Saker's also optimistic about Sun Microsystems, Six Flags, ATI Technologies, CGI Group, Gateway and Durban Roodepoort Deep, the South African gold mining company. He would avoid Compuware, Corning, American Airlines, JDS Uniphase, Lucent, Nortel and Tellabs.

But, Bensignor warns, “If you think that all the bad news about a company must already be factored into a stock price that's under $5, don't count on it.”

With all these caveats, Bensignor thinks that sub-$5 stocks could offer some speculative investors an opportunity for short-term gains. “If a stock has collapsed 80 or 90 percent, there could be an opportunity in trading it once it has established a base for a month or two and if there are signs of a technical recovery to help support a rally.”

More than likely, some sub-$5 stocks will dodge the bullet and turn around. But since such recoveries likely will depend on improvement in the broad economy, most clients would probably be better off sticking with companies that have better weathered the bear market and whose stronger financial positions allow them to more easily exploit improving market conditions.

For speculative investors who think there's tremendous opportunity with these shares, a hedge fund or mutual fund that specializes in small cap stocks may be the best option (see Mutual Funds, page 71). This would diversify risk and offer active management to achieve timely purchases and sales.

If any of your clients has ridden these shares down this far, just remember: If lucky enough to be reporting any capital gains, dumping his positions could save him more money in taxes than he may ever see in any upside of these stocks.

Today's “Penny” Stocks/NYSE and Nasdaq Stocks Trading Under $5

Here are some stocks that have recently tumbled below $5. Many of them possess market caps that exceed $1 billion and remain actively traded and liquid. Most have fallen precipitously this year and are trading near their 12-month low, suggesting that they haven't yet formed a base. And for those with rated debt, virtually all have fallen below investment grade.