The Myth Of The Low-Priced Stock

by: Tim McAleenan Jr.

MSN Money recently ran the article "10 Stocks Under $5 For 2012" by Robert Holmes, which polled research analysts on the best companies out there trading for under $5 per share. Here's what Holmes had to say about searching for stocks with this share price:

Cheap? These companies might be bargains. Sprint Nextel (NYSE:S) and US Airways Group (LCC) may be among the best inexpensive stocks for 2012, if analysts are to be believed. After a roller-coaster ride in equity markets this year, investors are more than willing to look ahead. Record volatility has forced investors out of riskier assets and into large-cap stocks with dividends-or out of the market altogether. While some investors will continue on a path to safety, others may find more opportunity (and risk) in stocks trading under $5, which typically don't receive attention from mutual funds because of their miniscule [sic] share prices. But many low-priced stocks were big winners this year, including TeamStaff (TSTF), Majesco Entertainment (NASDAQ:COOL), and Adolor (ADLR).

This type of attitude toward investing is absolutely awful. First, it seems to take on faith the premise that somehow $20 stocks are cheaper than $30 stocks, and in this case, $5 stocks are cheaper than other stocks in the market. While a $4 stock may very well be cheap, we can only make that determination by evaluating the earnings power behind each share of the stock. After all, if Company X's stock were to trade at $1,000 per share but represented $100 in earnings, it would be a much better bargain than if Company Y traded at $3 per share and only generated $0.01 in annual earnings.

One trick that I personally like to do is create a spreadsheet that boils down the price of a stock to a $1 so that I can know how much earnings and dividends each dollar invested into the company represents. I'll use Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), and McDonalds (NYSE:MCD) as examples to show you what I mean.

This way you can ensure that you are making a more apples-to-apples type of comparison when you are looking at the value of the earnings and dividends that each dollar invested represents. Once you distill it in this format, you can easily see that every $1,000 invested in Procter & Gamble represents $58.90 in annual earnings, $31.40 in annual dividends; every $1,000 invested in Johnson & Johnson represents $62.10 in annual earnings, and $34.50 in annual dividends; every $1,000 invested in McDonalds represents $50.60 in annual earnings, and $27.70 in annual dividends. This is by no means enough due diligence to make an investment, but it does get you started in the right direction for understanding the earnings and dividends represented by every dollar you invest.

That's what makes this type of article so frustrating. Investors ought to know that a stock is cheap when they can buy the greatest amount of future profit at the lowest risk-adjusted price, yet articles like these try to reinforce the novice perception that stocks with low share prices are "cheaper" than those with higher share prices.

This type of thought process is not conducive to intelligent investment, and lines like "record volatility has forced investors out of riskier assets" reinforces this thinking. The basis of sound investment is that you know why you own everything in your portfolio so that mere volatility alone will not force you to sell a holding. Even with "safe" blue chip stocks, volatility is the price of admission for the outsized gains over the long-term.

Shares of Coke, Johnson & Johnson, Procter & Gamble, Colgate-Palmolive (NYSE:CL), General Electric (NYSE:GE), and Hershey (NYSE:HSY) have seen their shares fall by 40% or more from their highs at some point in the past fifteen years, which implies that a bumpy ride often comes with the territory of long-term stock investment. If volatility alone scares you out of investments, then you are most likely putting yourself in the position to do the opposite of the "buy low, sell high" wisdom of investing.

I don't think investors are doing themselves any favors by specifically looking for stocks that trade around $5 per share (or any specific level, for that matter). When investment articles suggest that share price alone somehow represents "cheapness," I think investors enter a realm that deviates from what stock ownership actually represents -- a proportional share in a real business that generates real earnings and real dividends.

As an investor, it's often best to seek the greatest amount of future profits possible on a risk-adjusted basis, and the suggestion that stocks below the $5 mark will get you there relies heavily on perception rather than reality.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.