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Biotechs for pennies?

Have you spied a biotech stock selling for under $5.00 a share or even $1.00 a share? You certainly have a selection: shares of about 150 biotech companies from all over the world sell on US markets today for under a five spot. Conventional wisdom leads us to eschew these companies, called 'penny stocks', as a gambler's nightmare. But this is not always true.

Bulls, bears and penny stocks

Most of us have been taught that a low-priced stock is low for good reason: investors aren't buying because business is failing and there is nothing to prevent the stock from going to zero. This is generally true, but there are exceptions. In bear markets, herds of sellers indiscriminately trample prices of good and bad companies alike, whereas in bull markets, buyer enthusiasm boosts prices across the board. Therefore, low prices at the market's October 2002 nadir did not imply bad business performance as strongly as they would have in early 2000 at the height of the last bull market.

For now, let's say we have found an excellent biotech investing candidate whose shares sell for under $5.00, and we'll stipulate that the market today is neither bull nor bear. Should the low price put us off?

Not necessarily. Share price alone should not influence your investment decision if other reasons attract you (see Nat. Biotechnol. 22, 813, 2004). But once you have analyzed a business with favorable result, you must make sure certain important risks from a low stock price are absent before you buy.

Elephant in the room

Conventional wisdom holds that sophisticated large investors move stock prices. You and I do not have the financial power to buy or sell enough shares to substantially affect most stocks, but mutual funds, pension funds and insurance companies do. They are elephants in the bathtub: large investors trafficking in such huge sums that they can't get in or out without splashing water (the stock price) all over. Ideally, we want to precede a herd of elephants competing to buy or sell shares.

But in the case of penny stocks it is not that simple. Although one investor can slip into a bathtub with hardly a ripple, the same investor would make a splash by stepping in a puddle and large groups of investors jumping into the water at the same time can make as big a splash as one elephant. Not only that, but there are today many smaller money managers—little elephants—using strategies that do not care about the stock price if their investing analysis is favorable. Not only can they 'easily slip into the bathtub,' but when they act as a group, they can also cause 'a splash,' moving stocks with smaller daily dollar volume—illiquid stocks—quite nicely.

Caveat emptor , volatility and delisting

There are still real risks when prices head towards $1.00 and below. Illegal operators—penny stock promoters—can buy a stock and then use the Internet and other methods to spread false news, boost demand and share price and then bail out at the higher price before everyone else figures out the scam and escapes. This is called the pump-and-dump. In our metaphor, it involves herding everyone into the hot tub but stepping out before everyone realizes the water is dirty.

Pump-and-dump persists because people believe somehow that they can buy more shares of a $1.00 stock and make more money if it moves $1.00 than if a $100 stock moves $1.00, ignoring the logical fallacy that each stock is equally likely to move the same percentage—$1.00 or $100—depending on liquidity. They seek volatility, thinking they can trade the stock—gamble, really—and profit by timing the price's rise as other gamblers in the herd move the price. You can tell this is happening because the volume explodes when many gamblers are attracted, not necessarily due to penny stock promoters, either: note the volume of a LaJolla Pharmaceuticals (San Diego, CA, USA; Nasdaq:LJPC), recently priced at $1.15, or a Praecis Pharmaceuticals (Waltham, MA, USA; Nasdaq:PRCS) at under $2.00. Gamblers have moved in.

The worst and very real risk is that when a stock falls below $1.00 or a stock exchange's other minimum price, it may be delisted. If that happens, liquidity can dry up and investors may not be able to buy or sell easily or at all. This is almost always very bad news. You will usually have warning, because an exchange issues a notice of potential delisting to the company, and the company normally sends out a press release. You can find press releases for your company online where you track your portfolio.

Higher risk, but not forbidden

An academic would say that the stock price alone is a reason neither to buy nor avoid a stock. This is theoretically true. But once you have a candidate to buy and you see that it is a penny stock, beware that a low stock price can mean vulnerability to manipulation, indicate a business in danger of failure and a potential delisting. If you are satisfied that these won't happen—because of product prospects and cash reserves, for example—then the stock price itself should not bar buying.


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Tom Jacobs is cofounder of Complete Growth Investor (). He welcomes your comments at . Tom owns no shares of companies mentioned in this article.

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Jacobs, T. Biotechs for pennies?. Nat Biotechnol 22, 1509 (2004).

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