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My general rule about low-priced stocks that once were a lot higher but now trade typically lower than $5/shr is this: leave 'em alone.

The reason is that the odds of a recovery in the stock's business is not as good as the stock going down more, stagnating or going Chapter 11. If a "cheapie" gets cheaper -- if you've bought a false bottom -- you'll run into two negatives.

a) You are probably not smart to double down, putting good money after bad because this might violate your sell discipline and quickly prove to be what I call turning a mistake into a disaster.

b) While you wait for better days -- what reasons are there to expect these? -- you suffer opportunity cost by not having the capital tied up in the "cheapie" invested in a hopefully better stock.

After all, if a chimp's darts picked your stocks and you sold any that dropped say 15%-20%, then had your chimp throw another dart, well, sure, now and then what you sold could climb back up, but this "weeding your garden" strategy would in theory leave you with only winners or at least not losers.

Studies have shown that less than 5% of "cheapies" double in price within 2-3 years. Others fall into a rut or into bankruptcy. There are reasons a stock price has fallen to only a few dollars per share and they won't be encouraging unless an outgoing tide has dropped all boats. I remember in the fall of 2008 Art Cashin, long time UBS head of NYSE floor operations and highly respected market analyst, commented on TV that there were lots of well regarded big cap stocks selling for hat sizes: that's about as good a buy signal as anybody could want.

The chart below is a decade old now, "Current Value as a Percentage of Peak Value" (Market View, UBS Inc., 11 Nov. 2003, p.5), but the pattern isn't going to change much from decade to decade. The universe for this chart was the S&P 1500 (500 large cap, 400 mid-cap and 600 small cap). Of those, 143 (9.5%) had dropped 90% or more in price between 1993 and 2003. Only 18 (1 in 8) had recovered to within at least half of their original price.


(Click to enlarge)

Three other issues with cheapies:

a) Their management can have trouble borrowing money. Banks will insist on junk bond rates because, obviously, there is much higher than normal risk loaning to a company that might go Chapter 11.

b) Mutual funds, pension funds et al. are prevented by charter from buying cheapies because the usually low daily trading volume denies the liquidity a fund requires. This, of course, removes a source of deep pocket buyers whose interest in the stock might otherwise give it significant support.

c) As a non-institutional buyer with no crosses available to you (unless your order is large compared to average daily volume), you'll face a high percentage difference between the bid and ask. Your order will likely be a buy-stop at a penny above the market ask, to keep from being hacked on the execution. A buy-limit would probably just sit there because the market makers know you want the stock, so they'll wait for you to pay up. Never, ever buy a cheapie at the market. What you thought your ask would be will look really good compared to your execution.

If you like a cheapie's business and your research looks good, let others have the rush of seeing it go from $4/shr to $8/shr. Once you've seen a strong recovery pattern on the chart, then you could take an initial position. This gives you decent odds of avoiding further weakness and if you are right, you could have a winner heading into an uptrend.

But here's an inconvenient truth. Brandes Investment Partners did a study (The Focus, August 2004) in which they looked at stocks that had suffered big drops, then they looked again three years later. These "falling knives" in the U.S. (including those that went Chapter 11) beat the S&P 500 index by 6.6%/yr. A similar group of foreign stocks outperformed their country's MSCI index by 5.5%/yr.

These dramatic results illustrate that "falling knife" stocks are high risk for high gain. Brandes didn't say how many falling knives were in their study or what the bankruptcy rate was. Presumably they looked at enough stocks to make the results statistically significant.

You've heard, "Never try to catch a falling knife". The reason, of course, is that it's so easy to buy a false bottom. Many cheapies get a lot cheaper before they start, if ever, to show signs of life again.

So if you're tempted to buy some cheapies, go lie down and have your favorite beverage until the feeling goes away. Or go to Vegas. You'll likely still lose money but you'll have more fun doing it.

Source: Bottom Fishing: You Probably Won't Like What You Hook Into