It’s often repeated that many mutual funds aren’t allowed to invest in stocks below $10 share. But of course that makes zero sense because total market capitalization is what really matters. Who cares if a company issues a million shares of stock at $10 or two million shares of stock at $5? Either way things are exactly the same.
I get that mutual funds may be forbidden from investing in a company with less than X market capitialization, but I don’t see why the price of the share should be a criteria. Yet I hear this story all the time. Is there any truth to it? Is it true that many mutual funds really can’t buy stocks below $10 (regardless of the total market capitlization?)
Because stocks that low are “penny stocks,” and are subject to high volatility (the penny stock limit is $5, IIRC, but one of us could be mistaken as to the amount). Even regular investors have special regulations if they want to invest in these stocks, which requires that the broker not recommend the stock (unless they investor has a record of this type of investment) and that they do everything they can to warn you of the risks.
Since a broker can’t recommend a penny stock, a mutual fund certainly can’t be involved. I’d even think that, if they buy a penny stock, they’d need to send out warnings to all their customers under SEC regulations.
Investing in stocks of this price – regardless of capitalization – is inherently risky. And the point of mutual funds is to reduce risk.
Okay, just what is the link between the price of an individual stock and the risk? As the OP was perhaps trying to say, price of an individual stock depends on how many shares are outstanding - how finely the capitalization has been divided into stocks.
To take a somewhat extreme example, Microsoft as I write this is trading at $19.11 US. (Its capitalization is listed as $171.55 billion, so presumably around 9 billion shares are outstanding.)
Now, if for some crazy reason Microsoft decided to do a quadruple split, that would bring their price down below five bucks and into the ‘penny stock’ range. It would be a foolish thing for them to do as long as that conventional meaning is widely understood - but it wouldn’t have any real impact on the risk of investing in Microsoft as far as I can understand.
Is it the presumption that any company with a share price that low has started much higher, and undergone a corresponding decline in their market capitalization which should be a warning about their historical performance? I do see in Wikipedia that a reverse stock split (or stock merge) used to get out of penny-stock range is considered ‘a stigma.’
So, it sounds like when you’re launching an IPO or something similar, you want to choose the number of stocks available very carefully, so as to not discourage investment by having too few available, because price won’t necessarily go higher as the scarcity diminishes. But you also don’t want to have too many so the price is too low, and you can’t take a bit of a hit without landing in penny stock territory. Hmm.
Yes. It’s one of those things that shows how the stock market isn’t a model of perfect rationality. If a stock splits from $9 to $4.50 a share; a $1,000 investment is still worth exactly the same in both cases, but nobody wants to buy two shares at $4.50, even if they think one share at $9 is a good investment.
However, the SEC definition above requires a ‘penny stock’ to also be speculative and for a small company. If someone at General Electric made a mistake and accidentally did a 10-1 split (or whatever) that brought the single share price under $5, I don’t think it would be a penny stock.
Of course, if GE did get under $5/share for some reason other than the company’s business going in the crapper, they’d do a reverse split or something to get the share price back. Because the market isn’t rational, and being above $5 seems to mean something.
It’s not a rule, it’s a matter of perception. Penny stocks are issued at the lowest possible share price because they can’t get enough investors to buy into them at a normal price. If you can get a block of a hundred shares for $100 instead of $5000, though, you might want to take the risk as an amount you could more easily afford to lose. You do so understanding that you have much less of a stake in the company, since to get equal value the company has to issue 50 times as many stocks. So the market cap is not the sole number to look at. Your percentage of ownership is also important.
Solid companies don’t want that perception. People buy stocks in the hope of making money, either from dividends or from appreciation in the stock price. A company that’s weak to begin with has little chance of better future value. Getting a smaller share of a weaker company is not a bargain.
Stocks, at least on NASDAQ, IIRC, get delisted if they fall below $1.00 per share. Sometimes they’ll do reverse splits, or issue 1 share for every ten outstanding shares, just to get the price up. That’s why it’s always seen as the last desperation move before going under. It rarely works.
When a major stock descends to the under $5.00 range, it’s almost always a clear sign that bankruptcy is looming. At that point shares lose all their value, so a purchase is a bet on whether the company will survive. No good mutual fund wants to have the reputation of betting on a company’s survival. So not buying shares under $5.00 makes sense, even if there is no rule against it.
Volilaty in price tends to be absolute while the worth of a stock is usually relative. So for example if a stock share priced at $20 goes down one dollar, it’s lost 5% of it’s value. A stock share that goes from $5 to $4 has lost 20% of it’s value.