About

How low can some stocks go? Not just in terms of price, but in quality?

The market’s remarkable 50-plus percent meltup since early March hasn’t been an equal-opportunity rally. Lower quality stocks (generally companies with weaker balance sheets and riskier prospects) have tended to greatly outperform higher quality stocks (generally companies with lots of cash, little debt and proven businesses).

That rush to lower quality might seem counterintuitive at first, but it makes a lot of sense. After all, the greater the risk, the greater the reward, and with the Dow Jones Industrial Average ($INDU ) still 30 percent off its all-time high, market pros are looking to recoup losses as quickly as possible.

So what then do we make of stocks that can’t even break the buck-a-share plateau? Such securities are usually called penny stocks. They trade over the counter or on the Pink Sheets. They’re not subject to the same sort of regulatory requirements as stocks traded on major exchanges like NYSE and Nasdaq, and many mutual funds, pension funds and other institutional investors are forbidden from owning them.

In other words, investors needn’t pay attention to penny stocks. There are some exceptions, of course, but for the most part, over-the-counter issues are best left to pump-and-dumpers and other boiler-room grifters. They just don’t belong in most folks’ portfolios.

All of which makes it somewhat alarming that there are nearly 200 stocks trading on the NYSE or Nasdaq that fetch less than $1 a share, USA Today reported Monday — and they are in danger of being delisted and consigned to the netherworld of OTC trading.

During the meltdown the major exchanges suspended the rule that gets a stock delisted if it trades below a buck for 30 consecutive days. But the rule was brought back in early August, putting some household names, including Sirius XM Radio (SIRI ), Jones Soda (JSDA ) and Joe’s Jeans (JOEZ ), in danger of getting the boot.

That begs the question: What’s wrong with these guys that they couldn’t even get a tailwind from the rush back to risk and lower quality securities? As USA Today notes, there were nearly double the number of securities trading below $1 at the end of 2008, but the rally has since saved about half of them.

If you believe in traditional valuation theory, then the market is saying that the prospects for these companies’ future earnings or cash flow are not very good, says Tony Cherin, professor of finance, emeritus, at San Diego State University. Part of it is attributable to being overly pessimistic — the market is always too optimistic or too pessimistic. With these stocks the market is very pessimistic about earnings coming out of the recession.

Yup, poor earnings prospects don’t get much love from the Street. Jones Soda, for example, hasn’t posted a profit since June of 2007, according to Capital IQ, and isn’t expected to do so anytime soon, according to Thomson Reuters. Sirius hasn’t been in the black on the bottom line since March of 2003 — and isn’t seen producing positive earnings per share until 2011. And as for Joe’s Jeans? Well, it’s profitable and growing, but not enough to support a higher valuation than shares sport now. Indeed, for its current fiscal year, Joe’s Jeans is forecast to earn just 6 cents a share, according to Thomson Reuters.

True, just because a stock is in danger of delisting doesn’t mean banishment to OTC status is inevitable. Delisting is a lengthy process, the stock could come back, or the company could always pull a reverse split.

But unless you’re a high-rolling speculative investor, you’d do well to pretend these stocks don’t exist for now. The market won’t touch these low-quality equities with someone else’s ten-foot pole. Why would you?