While the pandemic-era hype surrounding speculative startups has subsided, the bursting bubble has brought about significant changes in market dynamics. Now a substantial number of U.S.-listed companies are trading below the $1 threshold, many of which originated as special purpose acquisition companies (SPACs) that went public during the peak of the blank-check boom, Markets Insider reported last week.
In response to this trend, the SEC last month implemented sweeping new regulations governing SPAC operations, although some SPAC experts question whether the regulations will serve much purpose and are also ambiguous, giving the commission broad powers to interpret the rules.
Meanwhile, according to a report in The Wall Street Journal, there has been a substantial uptick in the number of U.S.-listed stocks trading below the $1 mark, with 557 such stocks reported. That’s in sharp contrast to the few dozen in existence three years ago. For perspective, approximately one-sixth of the Nasdaq Composite now consists of penny stocks, reflecting the popularity of the exchange among small-cap issuers.
As these stocks remain listed on major exchanges, it’s a trend that’s leading to market inefficiencies, IEX Chief Market Policy Officer John Ramsay wrote in a post last week.
The extremely low price of penny stocks facilitates significantly higher trading volumes compared to more expensive stocks. This heightened trading activity can lead to distortions in capital allocation, as exchanges often base their incentives on a firm’s total share volume rather than stock price.
As an example, Ramsay explained, “By actively trading a stock priced at approximately 19 cents per share, a firm could generate 1000 times more trading volume with the same amount of capital than it could by trading Apple.” This is due to an incentive structure known as the “rebate tier system,” which encourages trading at very high volumes. Trading firms are incentivized to focus on stocks that offer the greatest trading volume “bang for the buck,” ultimately leading to more favorable pricing for their other trades.
The SEC has proposed restrictions on this practice, citing concerns about its creation of an anti-competitive environment. The argument is that eliminating rebate tiers would eliminate inefficiencies in exchanges, as capital flows would no longer reward stocks that manipulate prices.
Additionally, high trading volumes can mislead retail investors into perceiving sub-dollar stocks as attractive investments, even though these assets are already notorious for their volatility and high risk.
As Ramsay noted, “High trading volume influenced by factors other than the fundamental value of listed companies can absolutely increase the risk of substantial losses for investors who may not understand the reasons behind the increased volume.”
A report from Jefferies highlighted another trend, noting that stocks priced below $1 per share have gained popularity among retail investors through social media. The GameStop short squeeze in January 2021 is a prime example of the meme stock phenomenon. This also raises questions about whether investors are foregoing investments in more traditional stocks like the S&P 500 in favor of sub-$1 stocks and how this might impact liquidity in traditional stocks.
The inclusion of these sub-dollar stocks in indices such as the Nasdaq adds to their perceived legitimacy. Despite Nasdaq’s requirement for firms to meet a $1 threshold for their shares to continue trading, companies below that level are granted a 180-day grace period to comply. The result has been a surge in reverse stock splits, where companies reduce their share count to boost the stock price. Jefferies reported 255 splits in 2023, compared to 159 the year before, as exchanges seek to support companies in remaining publicly listed amidst a ho-hum U.S. IPO market.
Bottom line, when investing in microcaps – or any other publicly-traded security – abnormal trading volume and social media chatter are no substitute for individual due diligence on a stock-by stock basis.
