Conventional 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.