Penny Stocks: A Handy Tool for Enhancing Fund Performance?

• Published date: 01 August 2019
• Date: 01 August 2019
• Author: Young K. Park,Inwook Song
• DOI: http://doi.org/10.1111/ajfs.12268

Penny Stocks: A Handy Tool for Enhancing

Fund Performance?

Inwook Song

Korea Fund Ratings Co., Republic of Korea

Young K. Park*

Business School, Sungkyunkwan University, Republic of Korea

Received 3 October 2017; Accepted 1 December 2018

Abstract

This study analyzes the characteristics of penny stocks and the benefits of including them in

fund portfolios. First, we show that penny stocks provide abnormal returns that are not

explained by traditional factor models; the liquidity factor seems to account for the excess

performance. Second, we find that penny stocks can serve as a powerful investment vehicle

for expanding the efficient frontier of the conventional investment set and that including

them in fund portfolios improves a fund’s performance. Third, we find that penny stocks

held more by funds provide excess returns even for a 5-factor model that includes a liquidity

factor.

Keywords Penny stock; Fund performance; Fund manager; Security selection ability

JEL Classification: G11, G21

1. Introduction

The stock price effect is an anomaly related to penny stocks. First proposed by

Blume and Husic (1973) and Bachrach and Galai (1979), this effect is characterized

by a significantly negative relationship between abnormal returns and stock prices.

Kross (1985) and Bhardwaj and Brooks (1992) empirically show that the stock price

effect drives the firm size effect. Jaffe et al. (1989) find that stock price is a signifi-

cant factor explaining the January effect even after controlling for the firm size

effect.

Low-price stocks should have higher abnormal returns due to their higher

default risk, lower liquidity, and less available information. Thus, penny stocks

should show low-price effects. However, few studies have investigated penny stocks.

Several studies examine penny stock-related IPOs (Beatty and Kadiyala, 2003;

*Corresponding author: Business School, Sungkyunkwan University Business School, 25-2,

Sungkyunkwan-ro, Jongno-gu, Seoul, Republic of Korea 03063. Tel: +82-2-760-0418, Fax:

+82-2-760-0145, email: ykpark@skku.edu.

Asia-Pacific Journal of Financial Studies (2019) 48, 445–475 doi:10.1111/ajfs.12268

©2019 Korean Securities Association 445

Bradley et al., 2006; Fernando et al., 2004), but Liu et al. (2012) are almost unique

in examining the abnormal returns of penny stocks.

1

For the 2001–2010 period,

they find that, compared to normal stocks, penny stocks have higher returns, higher

systematic risk (beta), higher unsystematic risk, smaller size, a higher book-to-mar-

ket ratio, and lower liquidity. Their findings suggest that the abnormal returns of

penny stocks cannot be explained by traditional factor models. They suggest that

only liquidity appears to have significant explanatory power for the abnormal per-

formance of penny stocks. Jung (1997) examines penny stocks in the Korean mar-

ket. He defines penny stocks as securities with prices below ₩15 000 (roughly US

$15) and compares performance between penny stock portfolios and normal stock

portfolios for the period between 1994 and 1995. His results suggest that penny

stock portfolios do not show significantly positive abnormal returns relative to nor-

mal stock portfolios in either the statistical or economic sense.

The literature on the neglected firm effect and the abnormal returns of over-

the-counter securities is worth consulting since penny stocks not only have lower

trading volume and smaller size but also attract little interest from institutional

investors. In the neglected firm effect, first reported by Arbel and Strebel (1983a,b),

the stock returns and risk-adjusted performance of neglected firms are higher than

those of normal stocks. The lack of information on neglected firms causes risk

premiums to rise above the appropriate level. The literature on abnormal returns

for over-the-counter securities includes Ang et al. (2013) and Eraker and Ready

(2014). Ang et al. (2013) report that over-the-counter stocks have risk premiums

similar to those of under-the-counter stocks in terms of size, value, and volatility

but receive higher risk premiums for low liquidity. Eraker and Ready (2014) show

that, while the average returns of over-the-counter stocks are negative, their distri-

butions are positively skewed, implying that some securities have exceptionally high

returns.

The research on low-priced stocks and neglected firms is related to penny

stocks, but penny stocks have unique characteristics that are not explicable by con -

ventional theories. The high information asymmetry in penny stocks often provides

widely divergent investment outcomes. Many individual investors consider penny

stocks as a subject of speculation due to their lottery-like disposition, while risk

management and compliance codes often prevent institutional investors from

investing in them. These unique characteristics motivated us to investigate penny

stocks and the benefits of including them in fund portfolios. This study tests four

hypotheses.

First, we test whether penny stocks exhibit abnormal returns (alpha) that are

not explained by traditional performance evaluation models. Testing in the US mar-

ket, Liu et al. (2012) find that penny stocks are high in returns, high in systematic

and unsystematic risks, small in size, and low in liquidity. They also report that the

1

They define penny stocks as securities on NYSE, AMEX, and NASDAQ with an average

price less than or equal to five dollars in the previous 12 months.

I. Song and Y. K. Park

446 ©2019 Korean Securities Association