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Long list of penny stocks poses trouble for Investors

By Ali Jaffery

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With the stock market in tatters throughout the past 18 months, it's not surprising to find lots of low-priced stocks to choose from. More stocks on the Russell 2000 trade at $10 or less than at any time since the recession of 1990-91, mostly owing to the demise of the dot-coms and the collapse of the telecoms. More startling, 326 sub-$1 stocks litter Nasdaq's landscape -- close to 9% of the 3,736 domestic common stocks listed as of Feb. 28 on the "Stock Market for the Next Hundred Years."
Of that, 202 companies are on the National Market, a total equal to 6.6% of the companies listed there, according to the Center for Research in Security Prices at the University of Chicago. The rest reside on Nasdaq's Small Cap Market, where you might expect to find cheap stocks, but not penny stocks. Many of those companies have languished below a buck for much of the past year and many remain unprofitable with uncertain prospects.
Nasdaq is the second-biggest stock exchange in the U.S., behind only the New York Stock Exchange (which has stricter listing standards and where fewer than 2% of its stocks are trading under $1). By continuing to list penny stocks, Nasdaq may be laying a trap for small investors lured by the shares' sheer affordability and by casino dreams of big payoffs. It also may be avoiding an inevitable question: How have so many of the stocks it has listed soured so seriously, and often so swiftly?
Five to 10 years ago sub-$1 stocks would be pink-sheet stocks; now they're all trading on Nasdaq. Penny stocks are more easily manipulated. Indeed, many traditional money managers have mandates that prevent them from owning stocks under $5.
The most important thing to look at is not how many are trading below a dollar, but how many have done so for 30 consecutive trading days. But after the terrorist attacks on Sept. 11, Nasdaq imposed a moratorium on delistment and stopped enforcement actions to allow executives to focus on running their businesses. That helps explain why even stocks that had been trading below $1 for much of last year continue to be listed. The moratorium ended Jan. 2.
Nasdaq says there are "elaborate hearings and an exhaustive process" before a company is delisted. If a company's stock trades below $1 for 30 straight trading days, Nasdaq sends the company a warning and gives it 90 calendar days to become compliant. During that period, if a company's stock closes at or above $1 a share for 10 straight days, the cycle begins again and the stock would have to trade below $1 for a new round of 30 consecutive trading days before Nasdaq would take action. At that stage many companies announce recapitalization plans and reverse stock splits in an effort to boost share prices above the minimum threshold.
By avoiding draconian measures and by delaying action, Nasdaq is clearly betting some companies will benefit from a turnaround as business improves, and mergers and bankruptcies will likely remove other companies and the need for exchange action.
Nasdaq is also free to exercise discretion. The suspension provision says only that Nasdaq "may" delist a stock.
Individual investors tempted by cheap stocks should think twice. A study conducted last November, came to this stern conclusion on whether individual investors should buy stocks priced below $10 a share, particularly those below $5: "Clients should not touch them."

Study determined that the average annual return over the past 11 years of stocks on the Russell 2000 index priced below $5 was a loss of 5.8%; most of the poor performance came in the first three months of 2001, when stocks under $5 lost an average of 49.9%. Stocks trading above $10, on the other hand, gained 10.3% and topped the index average in all but two years.
For investors who insist on speculating in such cheap stocks, landing a winner can result in a big payday. Of the outperforming stocks under $10 in the study, 16.5% did so by more than 40%.

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