Are Penny Stocks Worth a Look?

By Jyoti Thottam

Penny stocks--those that sell for under $5 over-the-counter--are the slot machines of the equity market. Care to risk a couple of quarters? It's tempting, with the established exchanges now brimming with household names like Corning in the penny-stock range. The fiber-optic-equipment maker was once a $100 stock. Now it trades near a buck fifty. Wireless-phone company Sprint is at $9.25; computer retailer Gateway, $3.58; Sun Microsystems, $3.66. How can you lose? But as anyone who has been cleaned out by a 25[cents] slot can tell you, this is risky territory.

The trick is to separate the fallen angels from the real sinners. "If a stock is trading at $1 and it was trading at $50, it is telling you that unless a rabbit is pulled out of a hat, it is going bankrupt," says Jason Selch, analyst with Chicago-based Wanger Asset Management, which manages the Liberty Acorn Funds. Selch looks for orphans, stocks that have fallen so far out of favor that even brokers aren't paying attention to them. One orphan he owns is Navigant Consulting, which traded as high as $50 in 1999 and is now less than $6, a casualty of several class actions. Selch thinks the firm's current focus, financial-claims consulting, has promise. After initially misfiring by buying shares at $10, he bought shares at $2, a price that was equal to just the company's net cash.

Selch advises individual investors to wait for a stock to stabilize in a price band for several months. "When things are going down rapidly, there is a good chance they won't come back," he says. "If they were trading at $50 and came down to $2 and stabilized, changed management, then most likely they will recover. Maybe they won't recover to $50, but they will recover to something."

Of course, share price alone doesn't tell the whole story. Tom Saberhagen, an analyst for Aegis Value Fund in Arlington, Va., says a company can control, to some extent, the price range of its shares by executing a "reverse split." Technology companies in particular are using reverse splits--reducing the number of shares at the same market value so each share is worth more--to keep their share prices above $1. Any lower, and they will get kicked off the major exchanges. Instead of share prices, Saberhagen compares price per share against book value per share (assets minus liabilities). Using this approach, Aegis picked up OMI Corp., a shipping company in Stamford, Conn., that is trading for $3.73 a share, well below its book value of $5.75 a share.

Pay particular attention to debt. Stan Majcher, portfolio manager for Hotchkis & Wiley Capital Management in Los Angeles, warns that if a company trades below $2 and carries a heavy debt load, the chances of long-term survival fade. With plenty of cash and a sensible strategy, the odds are better. That's why Majcher likes Gateway, an unpopular view among some analysts. Its stock is trading 95% off its peak, after a series of missteps. Majcher expects PC sales to pick up eventually. With zero debt and $1 billion in cash on its balance sheet, Gateway is an unlikely candidate for bankruptcy.

If you don't want to play the game yourself, there are dozens of mutual funds specializing in undervalued small-cap companies. But even the pros come up with lemons on occasion. "We're very familiar with the fact that companies do go to zero," Selch says. That's the thing about cheap stocks. Sometimes you get even less than you paid for.

--By Jyoti Thottam