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The list of penny stocks (on Wall Street, that generally means a stock that trades below $5) now includes some leading Internet brands. eToys.com (ETYS) is at $3.81 a share, CBS MarketWatch (MKTW) at $4.53 a share, and iVillage (IVIL) at $2.75 a share. Some second-tier companies are now trading so low they're threatened with being delisted from the Nasdaq National Market, which doesn't let companies that trade below $1 a share stick around for long. PlanetRX.com (PLRX), for example, has traded below 50 cents a share for weeks and is planning an 8-for-1 reverse split to hike its stock price. Penny-stock status may sound kind of appealing. But if such low, low prices make you think a battered Internet stock is a bargain, better think again. "A low stock price isn't any indication of whether it is a good value or not," says Chuck Hill, director of research at First Call, "although individual investors are prone to thinking it is." Plus, a new set of dynamics affect stocks this cheap that can make it even harder for a struggling dot-com to dig out of a hole. LACK OF LIQUIDITY. Managers of mutual funds, pensions, and other large institutional accounts generally won't touch them. A big part of the problem is liquidity. It just becomes too difficult for big buyers and sellers to trade the amount of stock they need without driving the share price up when they get in or driving it down when they try to get out. Indeed, guidelines at many large institutions restrict buying stocks with a market cap that falls below $1 billion. For mid-size investment firms and mutual funds, the cutoff is often a market cap of around $400 million to $500 million, says Greg Kyle, president of Pegasus Research. Perception is also part of the problem. Basically, a very low share price makes it all too apparent to big-time investors that the company is damaged goods. It looks like you're holding a stock that is a potential bankruptcy case, Hill says. "That may not be the case, but perception-wise, there is that burden." "WALL STREET ORPHANS." The problems tend to spiral from there. Because institutions aren't interested, research analysts typically soon drop coverage of these low-priced stocks. Without research analysts to whip up excitement, even companies with an improving story to tell can have trouble getting the word out. Hill thinks this chain of events may be starting to happen to struggling dot-coms. Once that sequence is set in motion, other problems crop up. Employees lured with the promise of valuable stock options start to bail out. Eventually, all that's left are insiders and those with restricted stock, says Robert Burgoyne, technology strategist at Monument Funds Group. The stocks also no longer become eligible to buy on margin, which further erodes the potential pool of investors, says Arthur Hogan, chief market analyst at Jefferies & Co. Eventually, if a stock falls below $1 a share for 30 consecutive trading days (sometimes even if it falls below $5 a share), it may be delisted from the Nasdaq National Market. When that happens, liquidity really dries up. "If they are delisted, then for all practical purposes, they are Wall Street orphans," Kyle says. CASH SIPHONS. Still, the dot-coms may have a little more life than the typical penny stock. "The major houses have poured so much cash into these things, I don't think they are all set to let them die yet," says George Schlieben, publisher of the Internet newsletter Global Penny Stocks. "I think too many people have too much at stake to let most of them die." And, of course, delisted companies can go on for years -- and many do -- listed on the so-called pink sheets (compilations of stocks that don't trade on a major exchange), usually with a volume of just a few thousand shares a day. But most dot-coms don't have that luxury, because they aren't generating enough cash from operations to stay in business. They need access to capital markets to stay alive until they reach profitability. Without it, "they become bankruptcy candidates," Kyle says. Some of these companies will be acquired before they're in such dire straits. But investors should keep in mind that even then, the companies may not fetch much of a premium. "If you're looking for consolidation plays in hope of capturing a quick takeover premium right now, you can forget about it," Kyle says. Even with stock prices so low, potential acquirers may wait until the company is forced into bankruptcy and then buy the assets at fire-sale prices, Kyle says. POSSIBLE PICKS. Some ailing dot-coms also will recover. "Inevitably some do," Burgoyne says. "Between $5 and $10 a share, some are likely to dig out. Between $2 and $5, it is a really dangerous area." And there will ultimately prove to be some real bargains in this group. Kyle likes Razorfish (RAZF) , an Internet-consulting firm now at $4.69 a share. He also likes the chances for Barnes & Noble.com (BNBN) and CBS MarketWatch, partly because they have solid backing from large companies. Other market watchers also see potential gold in the ailing dot-coms. Out of 60 Internet stocks tracked by Robertson Stephens, 24 were trading below $5 a share as of Oct. 26, and analysts had buy ratings on 17, including eToys.com, fatbrain.com (FATB), MyPoints (MYPT), and Quokka Sports (QKKA). As for Schlieben, he got one wrong when he recommended Mortgage.com (MDCM), which announced Oct. 31 that it's closing up shop and fell to just 9 cents a share. But he also has picked some Net stocks that have bounced a bit recently, including Garden.com (GDEN) and FTD.com (EFTD). Still, he warns that in the current bear market for tech stocks, even battered dot-coms that rebound won't earn the high returns many penny-stock investors expect. LITTLE UPSIDE. "Six months ago, some great news would have sent them up 80% in a day or two," Schlieben notes. "Now, maybe you'll get 20%." Worse, a turnaround in the market won't provide much upside either. Many of the now-downtrodden companies went public based on high hopes for a concept that hasn't worked as planned. Many of them probably shouldn't have gone public in the first place, Hogan says. "Not all these things were public-company-worthy." For investors eyeing the new Internet penny stocks, Hill has one old-fashioned piece of advice. "Buyer beware," he says. Just because something is cheap doesn't mean it's a bargain. Stone is an associate editor at Business Week Online EDITED BY THANE PETERSON |
