The Instinct to Favor Cheap Stocks Runs Deep
By Saghir Aslam
Rawalpindi, Pakistan
(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the Ummah will benefit from this effort through greater financial empowerment, enabling the community to live in security and dignity and fulfill their religious and moral obligations towards charitable activities)
Unless you’re a disciplined growth investor, the instinct to favor cheap stocks runs deep. From youth, we learn to bargain hunt.
But financial markets often defy our instincts. And so it is with bargain hunting for stocks that cost $1, $5 or even $10. Cheap stocks usually are cheap for good reason. Buying them can put you into laggard companies that will undercut your portfolio’s performance.
It’s true that the crowd can fall prey to bouts of euphoria and fear that lead the market to overprice or under price stocks. But more often than not, the market is pretty efficient at pricing financial assets.
Each day, legions of analysts, strategists and money managers sift through the stocks that make up the market. Their collective decisions, as well as those of millions of individual investors, put a price on every stock, usually close to what it’s worth.
So it’s unlikely that you will be a big winner just because a stock looks cheap. In fact, the contrary is true.
The lower a stock’s price, the less likely it has a good earnings history. And profits are the most important driver of stock performance. Stocks under $10 have an average Earnings Per Share rating of 39, a weak score. It means almost two out of every three stocks have better earnings growth than shares selling for less than $10.
Higher-priced stocks tend to attract institutional money, the key to a stock making a huge, substantial move. Why? One reason is that big buyers and sellers of stocks prize liquidity. They want to be able to move in and out of stocks without causing wild spikes in price. For that reason, many mutual funds have a minimum price limit that forces them to avoid cheap, illiquid stocks.
Low-priced stocks can suffer from extreme volatility. A ¼- or ½-point move in a $5 stock is a big percentage change-nice on the way down. A 1-point decline in a $5 dollar stock means a 20% loss. A 1-point move in, say, a $25 stock represents 4%.
Very cheap prices also can carry greater transaction costs. That’s because the spread between the bid and ask prices for a low-priced stock amounts to a far greater percentage. The bid is the price where you can sell a stock instantly. The ask is how much you have to pay in order to get an immediate execution on your order.
A low-priced stock might trade at 5 bid and 5 ¼ ask. That 25 cents amounts to a transaction cost of 5%. That means the stock has to rise 5% before you’re assured of getting out even. Now take another stock that trades at 50 bid and 50 ¼ ask. That spread amounts to a transaction cost of 0.5% per share, insignificant in comparison.
Looking for cheap stocks also doesn’t work well when using price-to-earnings ratios. According to conventional wisdom, low P-E stocks are a better value.
Say a company earned $1 a share last year and its trading for 40. That gives it a 40 P-E, which is high by historical standards. Another company with the same earning but selling for $10 would carry a P-E of 10.
The cheaper shares seem to be a better value because they cost you only $10 to get that $1 in earnings. Sounds logical, but it is true?
A stock with a PE ratio of 40 implies that investors expect the profitability of the underlying company to increase to justify the multiple. A stock with a PE on 10 suggests a comparatively moribund earnings future.
Indeed, studies of the best-performance equities show that winning stocks typically have a P-E 20% higher that the rest of the market before they begin their big advances. If you insist on cheap, low P-E companies, you almost guarantee yourself that you will never buy a leading stock.
Over the years, I personally have done much better with higher priced stocks. In my earlier investments days, years ago, I have bought cheap stocks. Traditionally, I do not buy stocks under $20. They have taught me a lot about investments and were a great learning experience.
(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, nor does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr Aslam does not have anything for sale.)
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