Too Good to Ignore? A Primer on Listed Penny Stocks

Abstract

This paper identifies distinct characteristics of U.S. penny stocks listed on NYSE, AMEX, and NASDAQ. They are characterized by high return, high beta, small capitalization, high book-to-market ratio, high idiosyncratic volatility, and poor liquidity. The liquidity costs as measured by Gibbs effective transaction costs for penny stocks are more than twice as large as the magnitude of non-penny stocks. Abnormal returns of penny stocks estimated using the Fama-French (1993) three-factor model and the Carhart (1997) four-factor model become insignificant after additional risk factors capturing short- and long-term return reversals and liquidity risk introduced to the asset pricing model. Although abnormal returns are insignificant for the entire penny stocks in the context of the seven-factor model, zero-cost portfolios built on firm characteristics (such as firm size, value, momentum, and idiosyncratic volatility) yield significant profitability. Because these results are sensitive to portfolio weighting scheme (value vs. equal weight) and the lengths of holding periods, further analyses are warranted for trading strategies.