Penny Stocks or Deep Values?

Penny stocks. They come with the stigma of hype, manipulation, or worse. But do they deserve it?

Usually, but not always. There are risks, but also the caveat that many great values -- some familiar to our readers who have profited from them -- come from The Land of Cheap Stocks. I'll offer those and a new one, but first let's define our terms.

A penny stock is one that sells for less than $5 a share. But is this a sensible boundary? Our TMF Community members have looked at the history behind it and debated. One excellent point is that there are many well-known, widely held, and heavily traded stocks selling for less than a fiver.

Consider telecom equipment makers Lucent Technologies (NYSE: LU  ) and Nortel Network (NYSE: NT  ) , which closed yesterday at $2.38 and $4.68, respectively. They are technically penny stocks, yet how easily can individual investors manipulate them, given their market caps of $9.9 billion and $18.5 billion and daily trading volume in the tens of millions? How susceptible to manipulation are any of the following companies with low stock prices and billion-dollar market caps:

                              Stock   Market  DailyCompany                      Price   Cap     $ Vol.Atmel   (Nasdaq: ATML  )          $4.85  $2.3B $  40MJDS Uniphase   (Nasdaq: JDSU  )    3.92   5.7B   120MSirius   (Nasdaq: SIRI  )          2.28   2.3B    75MSun Micro.   (Nasdaq: SUNW  )      3.54  11.5B   175M
Prices at 10/13/03 close. B=billions, M=millions.

With these trading volumes, it takes institutions -- not individual investors -- to move prices. So we go farther to define a penny company as one that not only falls under the stock-price limbo stick but also has a market capitalization below $100 million (or, for some, below $250 million).

These arbitrary limits capture a principle: Cheap shares are often cheap for a reason. The company's business is in deep trouble, and the cheap shares becomes targets for manipulators. Beware.

Pump and dump
Bill Mann describes in Hype, Spam, and Penny Stocks the explosion of email penny stock scams, as well as the stocks' horrible investing returns. They usually sell for under $1 a share, are listed on the OTC Bulletin Board or Pink Sheets, and are trumpeted as "poised to move."

And move they do. If you send out a gazillion emails and anyone buys the thing you're flogging, of course it moves. It's the ol' pump and dump. That is, someone pumps up the stock with PR, the price moves, and they sell before you -- leaving you holding shares that decline rapidly.

Thin volumes
These dramatic price swings are only possible if a third criterion is present: dangerously low volume. A lot of individual investors descending on a thinly traded stock can jolt the price because of the paucity of buyers and sellers bidding for shares. That's why even if you are going to buy a decent business whose stock is thinly traded, it's a good idea to place a limit order to avoid getting stuck with a higher price that starts you out with a handicap. (You already eliminated the threshold handicap by choosing adiscount broker, right?)

Note: If you ever place a trade in pre-market or after-market trading, you must place a limit order, because almost all stocks trade thinly during those hours.

Case in Point.360
I learned all about the capacity for quick price moves in penny-company stock prices last month, when I wrote about media asset manager, Point.360 (Nasdaq: PTSX  ) . I believed the company, selling at $2.77 a share and notwithstanding its $25 million market cap, offered deep value. Check out the column for the full story, but here are the highlights.

The company toils in a very competitive business universe providing media management for Hollywood and corporate customers. It edits, masters, reformats, or archives anything from ads to feature films, and then can deliver and distribute them worldwide.

Six big Hollywood studios provide 35% of Point.360's business. But whether the customer is large or small, this world is all about relationships -- not long-term contracts -- and meeting deadlines. Someone calls you and needs video or audio production yesterday. These unlucky souls probably are late, too, and face the guillotine if they don't produce on time. If you make them look good, they're yours.

The company is in a turnaround. Excellent execs are improving working capital management and paying off turnaround-related debt ahead of time. From the darkest days, the CEO bought mountains of shares with his own cash, apart from options. With 10 consecutive quarters of positive free cash flow, the stock, as of Aug. 29, sold for an enterprise value-to-free cash flow multiple of 4 and P/E of 9. Cheap.

Apparently, others agreed. The stock closed on Friday, Aug. 29 at $2.77, and the column appeared on the next trading day, Tues., Sept. 2. That day, Point.360 closed at $3.54 -- up 28% -- and kept rising over the next five days to hit $4.15, a gain of 50%! Tuesday's volume jumped 50 times from Friday's. A month and a half later, it closed yesterday at $3.72. Shares are less of a bargain than at $2.77, but still well below my estimated intrinsic value of $8.91 to $11.

More deals in a bear market
At various times, Fool analysts selected ValueClick (Nasdaq: VCLK  ) or The Sportsman's Guide (Nasdaq: SGDE  ) , both penny companies at the time. Yet they offered excellent investment opportunities and have trounced the market averages many times since. Good companies like these appear at penny-company valuations more in bear markets when stocks, good and bad, fall to low prices.

But they are much rarer in rising markets such as today's -- with the Nasdaq up 62% and S&P 500 up 32% from their Oct. 2002 lows. When the broad market explodes, anything that's left behind is more likely to be a lousy business.

The bottom line: Be careful if you choose among penny companies. Only consider those where the value case is extraordinarily strong.

Parting moon
I spent part of the weekend at a Zen Buddhist retreat center in rural Minnesota, for a friend's ceremony to mark his commitment to lay teaching. There were raging fall colors, a full moon, and the first good rain in months; I fell asleep to the sounds of cows that sneaked through fences to munch the newly fed grass.

It's great to take a break even from the fun of investing -- hunting for growth and value in annual and quarterly reports, spreading the spreadsheets, applying judgment -- to keep up with changing seasons and old friends.

And to keep up with my columns or any other Fool writer's, check out the handy drop-down menu on the Fool.com main page ("Browse Stories By Author" below "News & Commentary") for each writer's archive. Or, if you'd like an email reminder -- no spam! -- whenever I publish a column, send me an email at tcjmail@cs.com with "Mailing List" in the subject.

Have a most Foolish week, and thanks for reading.

Writer and Senior Analyst Tom Jacobs (TMF Tom9) is long Point.360, Atmel, Sun Microsystems, and The Sportsman's Guide. To see his stock holdings, view hisprofile, and check out The Motley Fool'sdisclosure policy.


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