Cheap Stocks Aren't Always Bargains - Barron's

by: Rachael Granby

Plenty of stocks look cheap right now, says Barron's Eric Uhlfelder, but that doesn't make them bargains. Once a stock slides below the $5 mark, it's usually a long, tough climb out of the bargain basement.

In 2008, many of the companies that became penny-stocks were household names, or at least well-known on Wall Street. They included retailers Rite Aid (NYSE:RAD), Pier 1 Imports (NYSE:PIR), Eddie Bauer (EBHI); radio broadcasters Westwood One (WON) and Sirius XM Radio (NASDAQ:SIRI); auto-parts firms Dana Holding (NYSE:DAN) and Noble International (BATS:NOBL); and financials Friedman Billings Ramsey Group (NYSE:FBR) and Thornburg Mortgage (OTC:THMR). Other notables were Citigroup (NYSE:C), which has touched $0.97, and AIG (NYSE:AIG), which has traded as low as $0.33.

Historical data suggests that risks rise as stocks break through certain price points on the way down. Low priced stocks could be subject to greater volatility on less liquidity, decreased visibility and research coverage and the potential for de-listing. The relaxation of listing standards will slow the pace at which stocks are forced off exchanges, but this just means more listed stocks will be trading for less than $1, not that the stocks are better buys. Moreover, margin-buying opportunities become restricted and many institutions cannot hold stocks trading below a set level like $5.

This is bad news for major companies that dropped below the $5 mark, like General Motors (NYSE:GM), CB Richard Ellis Group (CBG), CIT Group (NYSE:CIT), Office Depot (NYSE:ODP) and Sprint Nextel (NYSE:S).

Former Fidelity Magellan manager Peter Lynch is skeptical of single-digit stocks, and believes investors ought to sell immediately unless they are confident enough to buy more stock. "The notion that if it gets back to $10, I'll sell [virtually assures a] whole painful process [that] may take a decade, and all the while you are tolerating an investment you don't even like."

This isn't to say that low-priced stocks are without fans. But the key point for many investors is if you've done your homework and still like the stock, hold on. If not, breaking the $1 mark (or the $5 mark) is a good signal to sell.