Why Low-Priced Stocks Could Be Lousy Investments

November 6, 2016
By

This week, I recommended a stock that trades above $200 a share to my subscribers.

I heard back from some of them almost immediately.

“What is the point of buying a stock this expensive?” one fumed. “The easy money is clearly behind us now.”

“Why buy a stock that costs this much?” asked another. “It’s easier for a $5 stock to go to $10 than for a $200 stock to go to $400.”

These investors are being tripped up by their own misconceptions.

Misconceptions that have no supporting evidence whatsoever.

Yes, a car that sells for $89,000 is more expensive than one that sells at $24,000.

But a stock that sells for $200 is not more “expensive” than a stock that sells for $20.

The company that sells for $20 a share may even be larger, perhaps much larger.

For example, if Company A sells for $200 a share and has a million shares outstanding, it is a $200 million company. If Company B sells for $20 and has a billion shares outstanding, it is a $20 billion company, or a hundred times larger.

More to the point, the stock price alone never tells you whether a company’s shares are expensive or not. To know that, you have to relate the price to sales, earnings, book value and other metrics.

A stock is generally considered more expensive if it sells at larger multiples. For example, if two companies are both growing at 20% year over year, but one sells for 20 times earnings and the other sells for 30 times earnings, investors will generally say the latter is more expensive.

Yet even that analysis is facile because what really matters is future earnings – not past ones.

If the company selling for 30 times earnings doubles its profits in the year ahead, while the other simply maintains its 20% growth rate, it may turn out that the one with the 30 P/E was the better value.

Yes, most investors like to buy in round lots (100-share increments). But depending on your available cash, that may not always be possible with a higher-priced stock.

Odd lots do not affect your investment returns, however. A stock that goes up 50% is just as profitable whether you bought 25 shares at $200 or 100 shares at $50.

But isn’t it easier for low-priced stocks to double?

Sometimes yes. But you won’t like the reason why.

Low-priced stocks tend to be thinly traded and easily manipulated. So they can skyrocket briefly on a news release or a newsletter recommendation and then plummet just as quickly.

William O’Neil, the founder and publisher of Investor’s Business Daily, has done a thorough survey of the best-performing stocks throughout history. The overwhelming majority of them were never penny stocks or anything close.

O’Neil recommends avoiding low-priced shares – and especially the dreaded penny stocks – entirely. As do I.

While it is not easier for a low-priced stock to outperform, it is easier for it to go to zero. Indeed, many of them look deceptively “cheap” on their way there.

Even a moment’s reflection on executive pay will tell you that low-priced stocks don’t outperform high-priced ones.

After all, in today’s world, much executive compensation comes in the form of option grants. The better a company’s shares perform, the bigger the executive bonuses.

If low-priced stocks performed better, why wouldn’t management simply split the shares down to boost performance – and hence, their own compensation? After all, splits are entirely at the discretion of a company’s officers and directors.

Lastly, I’ll point out that many of the best-performing stocks of the last decade are higher-priced shares.

Check out Apple (Nasdaq: AAPL), Amazon (Nasdaq: AMZN), Alphabet (Nasdaq: GOOG), Facebook (Nasdaq: FB) and Tesla (Nasdaq: TSLA) for example.

You might also glance at the best-performing holding company of the last half-century.

Buffett’s Berkshire Hathaway (NYSE: BRK.A) sells for more than $215,000 a share.

If that’s too rich for blood, you can always opt for the nonvoting B shares. They sell for closer to $140.

You should take that over a penny stock any day of the week.

Good investing,

Alex

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Source: Investment U



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