It has been a favorable month for America’s smallest stocks as investors seek likely beneficiaries of potential interest rate cuts and reconsider investments in the largest U.S. corporations.
The Russell 2000 index of small-capitalization stocks has risen 9%, while the S&P 500 blue chips have seen slight declines following recent drops. At the lower end of the market, gains have been even more substantial, with the Russell micro-caps index up 11%.
However, beyond these headline gains, a long-standing debate has resurfaced this month, potentially dimming the spotlight on small caps: the explosive growth of penny stocks, particularly those priced under $1. Trading in sub-dollar stocks has accounted for 14% of all U.S. volume this year, nearly double its level in 2022.
Recent surges in small company trading have produced unusual situations. In December, the most-traded stock in the U.S. by volume was a $2 million Chinese tea-shop chain planning to mine bitcoin. In May, the top two slots went to a loss-making 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 have, however, raised concerns among brokers and traders due to their frequent appearance among the most-traded names, suggesting irregularities.
Last week, market-maker Virtu addressed months of industry discussions about penny stocks by sending a letter to the Securities and Exchange Commission (SEC) urging major exchanges to tighten listing standards and for the regulator to mandate more disclosures from penny stock companies.
“We thought it was incumbent upon exchanges to be more rigorous around listing standards — we’ve discussed this with them,” said Doug Cifu, CEO of Virtu. “But sometimes the best way to be a catalyst in this industry is to speak up and say, ‘guys, fix this. It’s not good for investors or the market’s integrity.’”
Generally, shares priced below $5 are considered penny stocks under U.S. rules and are subject to extra broker checks due to their risks. However, this special handling does not apply to companies listed on mainstream exchanges, which are deemed to operate at higher standards. Nasdaq and the New York Stock Exchange do have delisting processes for stocks trading below $1 per share for extended periods.
As of Thursday, 448 exchange-listed companies were trading below $1, up from 108 a year ago and 67 two years ago, according to S&P Global Market Intelligence data.
Small stocks matter because they can cause significant disruptions. For instance, there was a rash of frauds among U.S.-listed Chinese companies around 2011. More recently, the meme stocks of 2021, which went wild, were small caps.
Many of today’s penny stocks top trading leaderboards due to their financing choices. Some have issued massive amounts of new shares, while others have issued bonds convertible into shares, often immediately and at a discount.
Ballooning share counts depress prices, while new stock sales boost trading volumes. Companies in the sub-$1 delisting danger zone can “reverse split” their stock, swapping hundreds of existing shares for one new one to increase the price. This process can be repeated.
Obscured by legalese in lengthy filings, the effects are not always obvious to investors. “These companies don’t have to perform any better — they do this corporate maneuvering and stay listed,” said one frustrated brokerage executive.
Brokers not only risk their reputations if clients grow angry over micro-cap maneuvering, but they must also cope with sudden changes in share counts. For example, Robinhood disclosed a $57 million one-day loss last year due to 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 calls for additional disclosures to clarify the dilutive impact of any bond sales.
Investors in micro-cap stocks may shrug off these issues. Those who favor this market segment are often risk-takers gambling on high rewards as much as they are believers in the next Tesla or Nvidia. However, no one likes to feel the goalposts moving mid-play. Virtu has raised an important issue that deserves more discussion.