The Penny Stock Anomaly
Exploring drivers of performance in low-price equities.
Despite the name, penny stocks generally refer to equities with a share price under $5. This is the definition that the SEC now uses, and it tends to be the cutoff used by the (limited) body of academic research. Most penny stocks trade over the counter, but, given that exchanges generally have a share price listing requirement of above $1, there are many penny stocks that also trade on exchanges.
At a quick glance, it would appear that penny stocks are an alluring source of blistering returns.
Figure 1: Average 12M FWD Return of Penny Stocks vs. Regular Stocks (1996-2024)
Note: 12M returns are clipped at -100% and +500% to mitigate the impact of outliers.
Source: Capital IQ, Verdad analysis
However, these eye-popping returns include equities with very low liquidity, some of which have extreme returns that significantly impact the average (even capped at +500%). Once we filter out any equities with less than $50K in average daily trading volume (ADV), we see a starkly different picture.
Figure 2: Average 12M FWD Return of Penny Stocks vs. Regular Stocks with $50K+ ADV (1996-2024)
Note: 12M returns are clipped at -100% and +500% to mitigate the impact of outliers.
Source: Capital IQ, Verdad analysis
Since most of the excess returns in penny stocks come from highly illiquid equities, what is left to say about the composition of penny-stock returns? Most notably, 3 things:
Penny stocks are extremely volatile (higher standard deviation).
Penny stocks, on average, have significantly worse returns than regular equities (lower mean return).
There are times when penny stocks do extremely well relative to regular equities.
We can see the characteristics of the cap-weighted universe below.
Figure 3: Cap-Weighted Characteristics of Penny Stocks vs. Regular Stocks (1996-2024)
Note: Returns shown above are total returns, not excess.
Source: Capital IQ, Verdad analysis
The lower average return and higher volatility of penny stocks are clearly demonstrated in Figure 3, but the question of when they do well is more interesting. It turns out we may be able to predict the periods in which penny stocks are likely to outperform using the high-yield spread, which we believe is one of the most powerful macroeconomic indicators. As a reminder, the high-yield spread measures the difference between the borrowing rate for below-investment-grade corporate bonds (typically issued by small, cyclical companies) and the corresponding US Treasury spot rate. Lower spreads indicate easily available money for investment, and higher spreads indicate tighter credit conditions.
We can examine penny stock versus regular equity returns against changes in the high-yield spread (i.e., one month change in the level of the high-yield spread) to see how performance compares.
Figure 4: Penny Stock and Regular Stock 3M FWD Returns vs. HYS Trend Decile (1996-2024)
Source: Capital IQ, Verdad analysis
We found that penny stocks tend to outperform regular stocks when the high-yield spread is falling quickly (cheaper borrowing costs for small businesses) and did notably worse when high-yield spreads were rising (more expensive borrowing costs for small businesses). High-yield spreads tend to fall most rapidly after sharp rises in spreads, which tend to coincide with periods of market panic. This is consistent with our prior research on crisis investing, in which we outline a strategy to maximize returns during market panics.
In summary, we have shown penny stocks generally have unattractive investment characteristics, with lower average returns and higher volatility than regular stocks. However, we believe the most liquid subset offers a source of predictable, compelling returns following periods of market panic, which we can time using the high-yield spread.
Jack Burton is a rising junior at Harvard studying History and Literature with a minor in Economics. In his free time, Jack enjoys reading, exploring the White Mountains, and volunteering at local schools. He’s looking forward to an internship at J.P. Morgan’s NYC office next summer.