Penny stocks are often perceived as high-risk, high-reward investments. These stocks, typically trading at less than $5 per share, attract investors chasing sizable gains but come with considerable risks. Recently, the Nasdaq stock exchange proposed new rules aimed at tightening the delisting process for penny stocks, particularly those that fall below $1 per share. This move is designed to protect investors from the heightened risks associated with these volatile securities.

 

What Are Penny Stocks?

Penny stocks refer to the shares of small public companies that typically trade for less than $5 per share. While some of these stocks are listed on major exchanges like the New York Stock Exchange (NYSE) or Nasdaq, most are traded over-the-counter (OTC) through the OTC Bulletin Board (OTCBB) or the OTC Markets Group.

Unlike the organized exchanges, the OTC market is a network of dealers all over the country linked by computers, telephones, and Teletype machines with no central location. Today, the OTC market for common stock consists of small stocks, illiquid bank stocks, penny stocks, and companies whose stocks trade on the “pink sheets.”

Penny stocks are usually associated with small companies that have low liquidity, meaning there aren’t many buyers in the market. This low liquidity can make it challenging for investors to sell their shares at a fair price. Additionally, penny stocks are often highly speculative, with a higher chance of significant losses, making them a risky investment.

 

Pros and Cons of Investing in Penny Stocks

Pros:

  1. Potential for High Returns: Many investors are drawn to penny stocks with the hope of large profits. Because these stocks trade at such low prices, even a small increase in value can result in substantial returns. For example, if a stock priced at $0.50 per share increases to $1, an investor would double their investment.
  2. Opportunities for Small Companies: Penny stocks can provide small or emerging companies with a way to access public funding. This funding can be critical for companies looking to grow or develop new products.
  3. Low Entry Point: The low price of penny stocks makes them accessible to investors with limited capital. This can be particularly appealing to those who are just starting in the stock market and want to invest without risking large sums of money.

Cons:

  1. High Risk of Loss: Penny stocks are extremely volatile and carry a high risk of loss. Due to their speculative nature, it’s possible for an investor to lose their entire investment, especially if the company behind the stock goes bankrupt.
  2. Lack of Information: Reliable information on penny stocks can be hard to come by. Many of these companies are not required to file regular financial reports with the Securities and Exchange Commission (SEC), making it difficult for investors to make informed decisions.
  3. Liquidity Issues: Because penny stocks often have low trading volumes, investors may find it challenging to sell their shares. This lack of liquidity can force investors to sell at a lower price than they intended, resulting in losses.
  4. Fraud and Manipulation: Penny stocks are sometimes targets for fraudulent schemes, such as pump-and-dump operations, where the stock is artificially inflated and then sold off by insiders, leaving other investors with worthless shares.

 

The Proposed Nasdaq Delisting Rules

The Nasdaq stock exchange recently proposed changes to its delisting rules for penny stocks, particularly those trading below $1 per share. Currently, if a company’s stock falls below $1, it has 180 days to regain compliance with the minimum price requirement. If it fails to do so, the company can request an additional 180 days and, in some cases, appeal the delisting decision to a Nasdaq hearings panel.

However, under the new proposal, companies that fail to meet the $1 minimum for 360 consecutive days will be suspended from trading, even if they have appealed the delisting decision. Furthermore, if a company has conducted a reverse stock split—a tactic often used to artificially boost share prices—within the past year, Nasdaq may immediately issue a delisting determination without granting the company a compliance period. Many companies use reverse stock splits to get their stock back over the $1 limit. For example, if their stock falls to $0.50, the company can do a 1 for 10 reverse stock split to reduce the number of shares by 10 times and increases the price of the stock to $5 (i.e., 10 times the original price).

This proposal aims to curb the practice of repeated reverse stock splits, which Nasdaq believes are often indicative of deeper financial or operational distress within a company. By tightening the delisting rules, Nasdaq hopes to protect investors from the risks associated with investing in companies that may not be financially sound enough to remain listed on a major exchange. While investing in penny stocks can be tempting due to the low entry point and potential for significant returns, it’s crucial for investors, especially novice investors new to the stock market, to approach these investments with caution and conduct thorough research before diving in.

In the Classroom

This article can be used to discuss stock markets and the over-the-counter market (Chapter 16: Financial Management and Securities Markets).

Discussion Questions

1.      What are penny stocks?

2.      Briefly describe the risks associated with investing in penny stocks.

3.      Describe the Nasdaq’s proposed delisting rule.

4.      Why do companies use reverse stock splits and what does this indicate for the company’s financial health?

This article was developed with the support of Kelsey Reddick for and under the direction of O.C. Ferrell, Linda Ferrell, and Geoff Hirt.