When a company's shares fall into penny-stock territory, the chances of ever recovering are typically very slim. Yet a handful of companies have proved that it's possible to come back from the abyss. Telecom-equipment giants Nortel ( NT) and Lucent ( LU) both fell below a buck a share last year and then bounced back to more than $2 apiece. Energy trader Dynegy ( DYN) also slid below the $1 mark last year, only to rally back to about $5. In a particularly stunning turnaround, Ask Jeeves ( ASKJ) went from a low of 86 cents last July to more than $13 now. So how did these companies do it? "Our general sense is that the characteristics apply differently to them than to the smaller-cap stocks," said Jim Kuster, managing director at Crest Advisors. "Large-cap stocks generally have more resources to get themselves out and more strategies that they can employ." Such gains are pretty remarkable, given that the survival rate for stocks that fall below $1 is usually very low. According to a study conducted by Crest Advisors, 82% of stocks that fall into this category never move higher than $1 again, and many just discontinue trading. The trend makes sense. After all, when stocks start trading for pennies, analysts often drop coverage, institutions dump their shares and liquidity begins to dry up. Still, this isn't what happened with Lucent, Nortel, Dynegy and Ask Jeeves. All four of these stocks continue to have a high level of institutional ownership.
In addition, analyst coverage of these firms has remained pretty solid. At last count, 31 analysts were covering Lucent and 37 brokerages were tracking Nortel. Five were covering Ask Jeeves and 10 were following Dynegy. These stocks have hardly dropped off the radar screen. Moreover, all of these companies have taken decisive actions over the past year, which have helped bolster their share prices. Ask Jeeves has been benefiting from stronger advertising revenue from so-called paid search services and recently agreed to sell off its lagging software-solutions unit. Dynegy, meanwhile, has sold off a number of noncore assets and recently raised its earnings guidance for the year. Lucent and Nortel have spent time paying down debt and generally improving their balance sheets, and both say they will be profitable this year. To be sure, many former highfliers did discontinue trading last year after falling into the penny-stock zone. And Lucent, Dynegy and Nortel aren't out of the woods yet because they continue to trade for less than $10 a share. A depressed share price can often deter lenders, making it harder for companies to raise cash. Lucent, for one, has been forced to rely on the convertible bond market to raise money, which will ultimately dilute outstanding shares. A low share price also can prohibit some institutional investors from owning the stock because many institutions have minimal capitalization requirements, or bylaws prevent them from purchasing a stock under $5. In some cases, mutual funds also are prohibited from buying stocks under $10 because there is concern that the stock is too speculative or because large block trades could influence the price.
So is there any way to determine which low-priced stocks will recover? Generally there's no set formula, but analysts say that stocks with a high average daily volume, lots of institutional ownership and a good following on Wall Street are more likely to do well. Kuster also said that firms dedicated to streamlining their businesses tend to see their stocks perform much better than companies who merely do a reverse stock split or take stopgap measures to boost their share price. But no matter how you slice it, the outlook for penny stocks is usually gloomy. According to Crest's study, only 16% of stocks trading between $3 and $5 ever traded above $10 again. For stocks trading between $1 and $3, the odds of that happening fall to just 9%, and for stocks that sank below a dollar, the chances of climbing back into double digits stand at a meager 3%. Another study by Thomas Watts, an analyst at SG Cowen, found that only 3.4% of stocks that fell into single digits rebounded to $15 or higher within one year. Still, in years following a major market shock, the odds did improve somewhat because bear markets tend to hit companies indiscriminately, even those with long-term potential. "In a more normalized market some of these stocks would never have gotten down below a buck," said Bryant Riley, CEO of B. Riley & Co.
Crest Advisory's Kuster said while the probability of single-digit stocks rebounding to $10 or more tends to be low, stocks like Lucent and Nortel aren't necessarily going to follow the typical pattern. "The difference that a Lucent or some of the other larger-cap stocks have experienced is that they still have a high volume of shares trading," he said. "That allows a stock to rebound in a greater number of circumstances than if a stock's volume is very low. Volume is definitely correlated with a stock's ability to recover."