Stay Out Of The Junkyard: Low-Priced Stocks Are Hazardous To Your (Financial) Health

by: Scott Fearon

My last post generated a fair amount of negative feedback on my Yahoo Finance page and on Twitter. There's nothing quite like waking up in the morning and being called an idiot (and worse) by all sorts of strangers on the internet. I understand that people have strong feelings about Fannie Mae and Freddie Mac, but I have to say, the vitriol of the comments took me by surprise.

Setting aside whether it was fair (or legal) for the government to change the bailout terms for Fannie and Freddie, my main point in writing about the two giant GSEs seemed rather straightforward: the low-priced stocks and preferred shares of Fannie Mae and Freddie Mac are extremely risky investments. If Washington formally nationalizes these companies (or does so informally, as it seems to be doing right now), there is a good chance that their stocks will go to zero. Sure, the big hedge funds and their armadas of lawyers might prevail in court and win the return of the companies' dividends to shareholders. But even if that happens, it will probably take years. As I wrote in the last line of the post, "There are easier ways to make money."

The broader lesson of the GSEs for both retail and professional investors can be stated in four words:

DON'T BUY JUNK STOCKS

What do I mean by junk stocks? There are all sorts of ways to answer that question. Usually, junk stocks are defined as companies with shrinking revenues, outsized debt loads and negative cash flows. But there's an easy way to spot junk stocks without digging through financial disclosures: if a stock is below five bucks, it is more than likely a troubled mess not worth investing in.

As I write in my book Dead Companies Walking, the vast majority of low-single digit stocks in the market are over- not under-priced. Almost all of them have been relegated to the stock market pick-n-pull for one (or more) of three reasons: a bad business, a bad management team, or a bad balance sheet. It's not uncommon for companies with sub-$5 stock prices to suffer from all three of these maladies. Yet, many investors cannot resist the temptation to buy these jalopies, hoping for a turnaround that almost never happens.

Like vintage cars, a small percentage of cast-off stocks do defy the (very long) odds and regain their former glory. But here's the thing pick-n-pull investors fail to understand: those stocks are even better buys at $8 or $10 than they were at $2 or $4. Why? Because improving fundamentals have taken hold by then, and the wider market has taken notice. Good news spreads quickly, and healthy, wealthy, and popular companies tend to get healthier, wealthier, and more popular as cash flows fatten and more investors pile in.

Consider how brutally top-heavy the markets have been this year. At the end of July, I (lightly) cautioned investors to be wary of the high-flying FANG quartet - Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Google (GOOG, GOOGL) - saying that any correction in the tech sector could also drag these stocks down to earth again. So much for market forecasting. Shortly after I wrote that post, the market did go through a correction. The FANGs fell along with everyone else, but they've all charged to new highs since then.

If you add the other two largest tech companies (Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL)) to the FANGs, these six behemoths now comprise 12 percent of the S&P 500's $18.5 trillion total market capitalization, and have accounted for just about all of the index's gains this year. If these half dozen names were flat, not up, the S&P would be down 1.5 percent year to date instead of up 1 percent. More importantly from an investment standpoint, the likelihood that any of them will go broke is exactly nil. They all have rapid revenue growth, strong balance sheets, capable Boards and highly educated employees. Those attributes are much harder to find at troubled companies with sub-$5 stock prices.

The top-heaviness of the current market might be extreme, but it isn't new. Historically, a minority of stocks have always outperformed the overall market over any lengthy time period. All the major indexes (minus the Dow) are market capitalization weighted. That means a few mega-cap winners, like Google or Amazon, can (and often do) offset the stock price declines at dozens, or even hundreds, of smaller companies. Though I usually don't buy the stocks of large, widely analyzed businesses, my own returns as a fund manager bear this out. My best performance has occurred when most of my shorts are below $10 (and hopefully heading toward zero) and my longs are pricier. In years where junk outperforms value (like 2003 and 2009), I tend to underperform.

A few years back, Blackstar Funds analyzed the returns of the Russell 3000 between 1983 and 2007. Even for a cynic like me, the bearish results were shocking. Of the 8000+ stocks that were either in the Russell 3000 originally or that entered it at some point during the study period (usually via an IPO), 39 percent produced a negative lifetime total return - with 19 percent losing over 75 percent. Only 1 in 5 stocks produced a 300 percent or greater return. And yet, over that same time period, the Russell 3000 gained over 1000 percent - all because a small handful of large winners crushed the median stock's advance.

In life and in the stock market, the rich tend to get richer. For everyone else, it's a different story.

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