Risk in Low-Float Stocks

Money Morning Article of the Week

by David Zeiler, Associate Editor, Money Morning

While often ignored in the financial media, “low-float” stocks should be in every investor’s vocabulary.   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 Stocks

But 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.

That’s one reason both Caesar’s and LinkedIn have significantly increased their floats since their IPOs, though both are still on the low side. LinkedIn’s float is up to 65.39 million shares, about two-thirds of the shares outstanding, and Caesar’s stands at 24.86 million, about 20% of the shares outstanding.

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 Stock

Unlike 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.