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It has been a good month for America’s tiniest stocks as investors have started looking for the likeliest beneficiaries of interest rate cuts while reconsidering going all-in on the biggest US corporations.
The Russell 2000 index of small capitalisation stocks has risen 9 per cent while the S&P 500 blue chips are marginally down on the month after recent sharpish falls. At the smallest end of the market, the gains have been even stronger with the Russell micro-caps index up 11 per cent.
But beyond the headline gains, a long-simmering debate went public this month that could take some shine off their moment in the spotlight: what to do about the explosive growth in penny stocks and, specifically, those priced under $1? Trading in sub-dollar stocks has accounted for 14 per cent of all US volume this year, almost double its level in 2022.
A recent surge in trading of small companies has produced strange situations. In December, the most-traded stock in the US by volume was a $2mn Chinese tea-shop chain with plans to mine bitcoin. In May, the top two slots went to a lossmaking scrap-metal merchant and an electric vehicle maker that had sold just four cars.
By value, such micro-caps represent a tiny fraction of the overall market. They’ve been causing unease among brokers and traders though, because their repeated appearance among the most-traded names suggests something odd is going on.
Market-maker Virtu last week broke months of below-the-surface industry discussions about penny stocks with a letter to the Securities and Exchange Commission that called for big exchanges to tighten listing standards, and for the regulator to require more disclosures from penny stock companies.
“We thought it incumbent upon exchanges to be a little more rigorous around listing standards — we’ve talked to them about this,” said Doug Cifu, chief executive of Virtu. “But the best way that I know to be a catalyst in this industry sometimes is to stick my head up and say ‘guys, fix this. It’s not good for investors or the zeitgeist of the market’.”
Generally, shares priced below $5 are considered penny stocks under US rules and are subject to extra checks by brokers because of their risks. But that special handling doesn’t apply to companies listed on mainstream exchanges because they’re considered to operate at higher standards. If a stock trades below $1 per share for a certain period though, Nasdaq and the New York Stock Exchange have processes for delisting them.
As of Thursday, there were 448 exchange-listed companies trading below $1, according to S&P S&P Global Market Intelligence data. There were 108 this time a year ago and 67 two years back.
Small stocks matter because they can cause big stinks. There was a rash of US-listed Chinese companies found to be frauds around 2011, for example. More recently the meme stocks of 2021 were small-caps that went wild.
The link between many of today’s penny stock crowd — and the reason they are topping trading leaderboards — is their financing choices. Some have sold massive amounts of new shares while others have sold bonds that can be converted into shares, often immediately and at a discount.
Ballooning share counts then weigh on prices while the sales of the new stock send trading volumes rocketing. Companies in the sub-$1 delisting danger zone can “reverse split” their stock, swapping hundreds of existing shares for one new one, to force the price back up. The whole process can be repeated.
Obscured by legalese in lengthy filings, the effects aren’t always obvious to investors. “These companies don’t have to perform any better — they do this corporate manoeuvring and they stay listed,” said one frustrated brokerage executive.
Brokers face not just the risk to their reputation if clients grow angry over micro-cap manoeuvrings, but must also cope with sudden changes in share count. Robinhood, for example, last year disclosed a $57mn one-day loss from its systems failing to register a sudden 25-for-1 reverse split by one company.
Virtu’s suggestions to the SEC include limiting the number of times a company can reverse split its stock and removing sub-dollar companies more quickly. It also asks for extra disclosures to make clearer the dilutive impact of any bond sales.
Investors in micro-cap stocks may well shrug. Those who like this end of the market are often risk takers gambling on moonshots as much as believers in the next Tesla or Nvidia. That’s all very well, but no one likes to feel the goalposts moving mid-play. Virtu has raised an important issue that needs more discussion.
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