The reason is simple. Low-float stocks tend to be much more volatile than stocks with larger floats.
Simply put, the "float" of a stock is the number of shares available to the public for trading.
It doesn't count shares owned by company officers and insiders.
In this case, it boils down to a question of supply and demand. Because of their limited supply, stocks with small floats can make major moves-either to the upside or downside.
Some companies exploit that same volatile potential in their initial public offerings (IPOs). Last year many tech companies used low floats in their IPOs to ensure a big first-day pop in the stock price.
"The more you constrain demand, the more likely, especially in a retail-oriented name, you're going to see a spike in price," Paul Deninger, a senior managing director at Evercore Partners Inc., told Bloomberg News.
The strategy worked for LinkedIn Corp. (NYSE: LNKD) last May.
With a tiny float of just 7.8 million shares - less than 10% of the shares outstanding - LinkedIn more than doubled its IPO price in its first day of trading.
An even more extreme example of using a low float to drive up an IPO was Caesar's Entertainment Corp. (Nasdaq: CZR) in February.
The initial float for Caesar's was just 1.8 million shares, a mere 1.4% of its shares outstanding. CZR doubled in price during its first day, and closed up 71%.
"I've never seen anything like it," Morningstar Inc. analyst Chad Mollman told The Wall Street Journal, in reaction to the low float. "I've been following IPOs, and we couldn't believe it when we saw it. You're creating an artificial demand and supply imbalance that leads to speculation."
The Perils of Low-Float StocksBut when share prices get inflated by such artificial means, the bubble-like valuation leaves it vulnerable to steep and sudden drops. If a low-float stock gets hit with bad news, it can plummet as quickly as it rose.
Companies that keep their stock float low, however, never shed the risk of a rapid loss in value. And it's investors who pay the price.
Take Travelzoo Inc. (Nasdaq: TZOO). Its unusually low float - just 7.46 million shares - helped propel TZOO briefly over $100 a share last April.
But a bad earnings report last July knocked Travelzoo down 22% in one day. And it only got worse from there.
Successive earnings reports disappointed as well, causing TZOO to surrender a total of 75% from last July to this April.
Another case in point is Netflix, Inc. (Nasdaq: NFLX). Its float is about 54 million, below average for a stock that has an average daily trading volume of about 6 million shares.
As of July of last year, the low float was a factor in pushing Netflix close to $300 a share.
The stock began to erode last summer when concerns about the company's subscriber base started to surface. By fall it was a rout, with NFLX plunging 35% in one day in October. Netflix bottomed out in the low $60s at the end of November, and currently trades at about $73.
You may have noticed that the range of the floats for those stocks is fairly far apart. Yet both are generally considered low-float stocks.
This raises a question that doesn't have an obvious answer: Exactly what constitutes a low-float stock?
Defining a Low-Float StockUnlike more widely known categories like market capitalization, low-float stocks don't have a specific definition.
Investopedia, for example, only defines a stock float while helpfully noting that "stocks with smaller floats tend to be more volatile than those with larger floats." But the site does not elaborate.
Some define low float stocks as those with fewer than 10 million publicly traded shares, but that includes a lot of penny stocks that most retail investors shy away from.
There's also the factor of trading volume.
For a low-float stock to be volatile, it also needs enough trading volume to push demand to levels necessary to move the stock price. Penny stocks, while almost always low-float stocks, usually don't generate enough trading volume for the low float to matter.
With this in mind, Money Morning decided to create a more investor-friendly definition of low-float stocks.
We started by eliminating the bulk of the penny stocks by filtering out stocks below a $300 million market cap. To pick the stock float cutoff point, we took the stocks that fell into this category (about 2,900) and looked for a logical cutoff point about midway through, which turned out to be 70 million shares.
To illustrate the extra risk that low-float stocks represent, we then compared the volatility of the group with floats under 70 million shares against the group with floats over 70 million shares.
To measure volatility we used the beta indicator. A beta of 1 means the stock's volatility mirrors that of the overall market. A beta above 1 means the stock is more volatile than the overall market. For instance, a beta of 1.30 means a stock is 30% more volatile than the market.
Then Money Morning filtered the results using four levels of average trading volume. As the chart shows, the low-float stocks were on average 10 percentage points higher than the larger float stocks, with the gap growing wider as trading volume increases.
That's a substantial risk, and one investors need to consider when doing their due diligence on any given stock.
It just goes to show that even though low-float stocks are not often discussed, you can't afford to overlook the amount of shares that are available to trade.
It's important to remember these stocks can go down as fast as they went up. Investors who ignore this aspect of a stock may be taking a risk that they don't understand.
Related Articles and News:
- Money Morning: LinkedIn’s (NYSE: LNKD) First-Quarter Earnings Preview
- Money Morning: Netflix (Nasdaq: NFLX) Stock Falls Out of Favor as Members Slip Away
- Money Morning: The 10 Keys to Short-Selling Profits
- Money Morning: Don't Get Burned by the New Tech Bubble
- Reuters: Travelzoo mulls sale, seeks adviser: sources
- Reuters: More challenges seen for Netflix, shares drop
- Barron’s: Is LinkedIn Already Tapped Out?