James Mackintosh reports at the Wall Street Journal that stock fundamentals are being ignored by investors. It’s not clear whether the cause is an influx of new investors who are ignorant of fundamental analysis, or heightened appetite for risk. Whatever it is, it’s probably unsafe for the market. Mackintosh writes:
Sometimes it’s hard to argue that market capitalism has any chance of correctly allocating money to the companies that can use it best. Case in point: Stock-market performance this year has been driven by the raw share price, with lower-priced stocks doing better and higher-priced worse.
Forget a careful evaluation of future cash flow, valuation, brand power, management skill or even political sensitivity. I repeat: The best explanation for how stocks have moved so far this year is the price of the stock, an almost meaningless number.
Stocks priced below $1 have performed the best, followed by those between $1 and $2, and so on up almost perfectly. The worst performers have share prices above $100. It looks remarkably like investors are treating a low-price share as an indicator that the stock is a bargain, and a higher price as a sign that it is worse value for money.
The share price on its own carries virtually no useful information: It depends entirely on how many shares the company has issued. A company can split a high priced stock to create more at a lower price, without making any difference to the intrinsic worth of the company. Equally, it can consolidate its shares to reduce the number, increasing the share price but again without any effect on how much the company should be worth.
The fact that the stock price at the start of the year is a near-perfect determinant of how a stock has performed is depressing, but at least in part explainable.
The depressing part is the unknown extent to which it is due to the rising popularity of trading by individual investors, who are more likely to be new to the stock market and regard a low-price share as cheap, even though it should be irrelevant to a company’s prospects.
The explainable part is that the pattern could partly be the result of the widespread willingness to pile on risk, because rules on penny stocks and delisting make certain types of stocks riskier.
Penny stocks are those that, despite the name, persistently trade below $5, and for which brokers have to provide warnings, with some exceptions. This makes them less attractive to investors. Below $1 they run the risk of being delisted by Nasdaq and NYSE, making them much harder to trade.
The result is that a very low stock price is taken as a sign of a poor-quality stock, even though it could just do a reverse stock split to consolidate its shares and push up the price again. Usually being poor quality works against a stock, but there has been a general dash for trash across the market since the prospect of more stimulus began to be priced in ahead of the November election, with riskier stocks doing better.
Read more here.