Cheap Stocks: Financially Devastating or Fantastic?
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Will cheap stocks make you rich, or destroy your portfolio?
There's a sure bet in the stock market that almost nobody plays which will virtually guarantee large investment returns.
There's another bet, however, that's sure to devastate your portfolio the longer you keep making it. Ironically, this fool's game is far more popular with the public.
Both bets fall under the general strategy of buying "cheap stocks" but, which you choose will have an enormous impact on your long term results.
Do You Really Know What Cheap Stocks Are?
When my father started looking for money managers I mentioned Warren Buffett's Berkshire Hathaway. His ears perked up, wanting to hear more. I told him about Buffett's fantastic record, the inherent diversification that comes with buying Berkshire Hathaway stock, and the likely returns going forward. Since so many money managers fail to beat the market, he was definitely interested.
But then he saw the price of Berkshire Hathaway's Class A shares -- way above $200,000 per share! -- and stopped dead in his tracks. He just couldn't get out of his head how expensive Berkshire Hathaway stock was, despite buying into the value investing philosophy.
When most investors think of cheap stocks they think of stocks like Elite Pharmaceutical, which sells for $0.37 per share, or Hudson City Bancorp, which trades below $9. Many people are drawn to cheap stocks such as these -- stocks trading at a low absolute dollar figure. We've all heard the adage "buy low, sell high," so it makes sense that investors would be drawn to these types of stocks. When it comes to buying low, after all, you can't get much cheaper than penny stocks, stocks trading below $1.
This scenario highlights a confusion about what a cheap stock actually is. The confusion really comes down to "cheap relative to what?" A stock has to be cheap relative to something, and that something is either its intrinsic value or its absolute price relative to stocks in general. In the first case, a stock is cheap if it trades 50% below book value, for example. By contrast, a lot of people look at the large cost per share of purchasing Berkshire Hathaway's A shares and consider those shares expensive, while at the same time automatically assuming that stocks trading for below $1 are "cheap."
Both distinct concepts have their place, but as you'll read below, combining the two leads to a powerful investment approach. Nail this and you're well on your way to great long term investment returns.
Cheap Stocks and the Essence of Value Investing
Let's turn first to a cheap stock price relative to fair value. Ben Graham once wrote that the margin of safety is the definitive characteristic of an investment. To understand this, it's important to recognize that every stock represents a piece of a business. At some point, management literally carved up their company into pieces and then sold off those pieces to individuals. Since the company as a whole has a certain value, so do those individual pieces of the company.
A stock quote, on the other hand, is just the latest price at which some of the company's shares were exchanged. This price may or may not reflect each share's actual underlying value.
Recognizing that price is different from value and then buying when prices are well below underlying value is the essence of value investing.
Who sells a business for less than it’s worth? -- you might ask. As I’ll show you later, sometimes the stock market causes people to do silly things.
Cheap Stocks Yield Spectacular Returns
Before we get to that, let me show you how good the returns are for stocks that are cheap relative to some fundamental value metric, as follows:
- Cheap stocks relative to dividend yield.
- Cheap stocks relative to earnings.
- Cheap stocks relative to cash flows.
- Cheap stocks relative to net assets.
Cheap Stocks Relative to Dividend Yield
One of the oldest ways to take advantage of cheap stocks is to invest in stocks with large dividends relative to the share price -- also known as large dividend yield stocks. Tweedy Browne, one of the top money management firms in American history, conducted a study of stock returns as they relate to various dividend yields.
From Tweedy Browne's paper, The High Dividend Yield Return Advantage:
This study only compared the top and bottom 30% -- how those 30% of companies with the highest dividend yield compared to those 30% of companies with the lowest dividend yield. It is possible to narrow down the field and invest in even higher dividend yielding stocks, which Tweedy Browne has done with spectacular results.
Here's one study that looks at UK companies:
Not all stocks have dividend yields, however, and dividends add in taxation that erode returns. While investing in high dividend yielding stocks is a great strategy both of these drawbacks can pose a problem if you're after the best results.
Cheap Stocks Relative to Earnings
One way around this is to take the focus off of dividend yields and place it squarely on the company's net earnings. Investing in low price to earnings stocks (Low PE stocks) has been a great way to earn high average yearly returns over the long run, for years.
Let's look at the results that Tweedy Browne has uncovered in their paper, What Has Worked in Investing:
From 1957 to 1971 cheap stocks in terms of price relative to earnings vastly outperformed in the stock market.
Here's how that same strategy worked in later decades, as shown in that same paper:
For all sizes of companies during later decades, cheap stocks dominate.
Cheap Stocks Relative to Cash Flow
Another way to look at earnings is to examine the cash that the company pulled into the business. Some investors consider this a better way to measure profit since it measures the actual money the company has left over at the end of the day -- not the accounting profit.
Buying at a low price relative to cash flow has been a good way to earn great returns in the stock market. Also, from Tweedy Browne's What Has Worked In Investing:
As shown in the table above, cheap stocks relative to cash flow do exceptionally well versus their peers.
In general, though, I don't like buying cheap stocks relative to earnings or cash flows since investing based on a low price to earnings can be very tricky and much more involved than it first appears.
This is why I shifted to investing in cheap stocks relative to the assets the company owns. As you'll soon see, I use a specific investment strategy for my own portfolio based on buying at only a small fraction of a company's assets -- and this strategy has vastly outperformed all other investment strategies that I know of.
Cheap Stocks Relative to Assets
When you buy cheap stocks relative to assets you're essentially buying at a low price-to-equity value. While there are a number of different ways to do this, the most basic involves just investing when the firm's price per share is well below the firm's equity per share. While this isn't my own personal strategy, it does serve as a good base from which to understand exactly what I do to earn average yearly returns above 30%.
Look at the following chart, also found in Tweedy Browne’s study:
I want you to ignore the absolute returns on the above chat for a second. Take a look at the top figure. As you can see, buying at an extremely low price to book value produces returns that are nearly double that of the market!
Investing based on assets has another key advantage: assets are far more stable than earnings, for the majority of companies. The accounting value of the equity of consistent businesses fluctuates far less than the earnings figure. While earnings can be artificially inflated due to a market cycle or one-time earnings windfall, assets are more or less stable. This makes investing based on assets much easier.
That’s probably why Walter Schloss said “earnings are manageable” and just bought cheap assets.
Cheap Stocks Relative to Intrinsic Value Represent Systemic Weaknesses in Human Psychology
Up to this point, it should be clear that buying stocks that are cheap relative to intrinsic Why would anybody give up a stock for a fraction of what it's worth, though?
Four simple basic human emotions are behind this anomaly:
- Greed.
- Fear.
- Pain.
- Pessimism.
Greed
First of all, there’s a reason why some stock prices soar.
A simple fact is that there is a serious information deficit on Wall Street. Investment returns depend totally on what happens in the future, but the future is not knowable -- all you can do is take an educated guess as to what the future holds. The desire to know, however, means that there's an ocean of people trying to predict future events, or tell how companies will fare going forward, and a sea of people following the advice of those fortune tellers.
Often an overriding theme can emerge: housing will rise forever, the internet will transform the economy and destroy traditional business, the Chinese economy will grow at 9 or 1% per year for decades... Investors latch on to these stories moved by greed -- the desire to get rich quick -- and prices surge.
But since the future is uncertain, forecasters are seldom right, eventually the rosy picture turns into “pumpkins and mice” and previous investors dump their stocks at whatever price they can get. Which takes us to the fear factor.
Fear
A rapidly sinking stock market can do terrifying things to a man's emotional state. Whenever stock quotes begin to grow red, a little pang of uncertainty triggers inside you. The investment choices you were once certain would pan out don't seem as certain anymore. When the market starts to free-fall, taking your stocks along for the ride, you might begin to worry that the temporary losses you're experiencing will turn out to be large portfolio-shredding losses, and try to sell before you suffer any more carnage.
Pain
Falling stock prices aren't just terrifying -- they can lead to potent psychological pain.
A slow steady slide down in price gnaws at you for months. You feel disheartened and jaded. You feel depressed.
There's a screen in that fantastic TV show Game of Thrones where Theon Greyjoy is being tortured. The torturer takes a knife and slices the flesh off his finger lengthways along the bone. While Theon is screaming, the torturer says that all Theon has to do to make it stop is to tell him to cut off his finger.
When it comes to painful paper losses, many people just want to sell to end the pain. This, unfortunately, often means offering up what is likely to be a great investment opportunity for the person who ends up buying the shares at depressed prices.
Maybe that’s why Warren Buffett says the stock market is a device that transfers wealth from the impatient to the patient.
Pessimism
After fear, and pain are gone, stocks that are left behind are surrounded by pessimism. Not only are there not many sellers -- since they all left when fear and pain took hold of their reasoning -- but now there aren’t even many buyers around. This is a recipe for very cheap stock prices, often way below the underlying value of the business.
That’s why renowned investor Sir John Templeton said “the time of maximum pessimism is the best time to buy”.
Incidentally, before you start buying stocks, you should consider whether you have the emotional skills needed to succeed in this field.
Cheap Penny Stocks: Why You Should Keep An Eye On Intrinsic Value
Earlier in this article I mentioned that there were two ways to think about what a cheap stock actually is. On one hand, we have stocks that are cheap relative to some source of value. On the other hand, there are stocks that are trading at some low absolute stock price. While we prefer the first way of looking at whether a stock is cheap, it's worth looking at why the second way has its appeal.
People are drawn to stocks with low absolute dollar values -- and penny stocks, in particular -- for various reasons. First of all, small business ventures often underlie penny stocks. People get easily sucked into a good story about a new disruptive technology device that will hit it big -- the “lottery ticket” mentality. Also, these small stocks are associated with high volatility and big price moves -- and for a good reason, as I’ll show you soon.
But it’s clearly erroneous to think -- like some people do -- that penny stocks limit potential losses because of their small size. If the company behind your $1 stock goes bankrupt then it doesn't matter what the shares were priced at -- you're still likely to lose everything.
It should now be much clearer why just buying based on a low absolute dollar amount alone can be so devastating. The share price just doesn't matter -- it's the price to value relationship that matters. If you buy based on a low share price and hype, you completely ignore the actual value of the shares. That's dangerous. Since there could be very little backing that share price, the shares may not even be worth the low price you paid for them.
Penny stocks are stocks selling below $1. Since they’re small, selling at such low prices, and probably very illiquid too, you might think they make very interesting investments.
However, among the penny stock universe, there are additional risks you have to consider. First of all, beware of the “pump and dump” scam. This consists of an individual or a group of individuals who buy penny stocks at very low prices, and then hype the stock in blogs, forums, or other places, mentioning they have some news about the stock that will shoot the price “to the roof”. Then, after unsuspecting buyers rush into the stock, they dump it at higher prices, leaving their victims with a worthless stock and painful losses.
Also, since these are very small companies with low regulatory requirements, minority shareholders are easy prey to dishonest management or abusive majority shareholders -- or both. This is a serious threat for small investors.
This doesn’t mean that you should avoid penny stocks altogether. What this means is you have to assess the intrinsic value of every stock you intend to buy and determine whether there’s a discount or not, and whether you believe management and controlling shareholders are honest or not -- in other words, you have to do your own research before you buy into any stock, penny stocks included.
Cheap Penny Stocks: Buying Cheap Stocks Relative To Intrinsic Value And On An Absolute Dollar Basis
Yet, what if you could buy stocks that are cheap both on an absolute dollar amount and relative to value?
Check out the following table:
Look at the upper row in the table. Regardless of their price relative to value, smaller companies tend to outperform larger ones by a wide percentage -- around 20% a year.
But we already knew this. If you look at the fifth column on the table above you can also see that small caps have median stock prices that are cheaper than larger ones, on an absolute basis.
These two datapoints are important -- tiny stock prices are often attached to firms with tiny market capitalizations. The correlation is pretty strong, but breaks down when firms are closer in market cap. While a company with a market cap of $1 billion USD almost always has a much larger stock price than a firm with a market cap of $100 million, a $90 million firm may have a larger stock price. So, generally speaking, we can assume that a firm with a tiny market cap has a smaller stock price than those with a larger market cap.
The point here is that you can actually buy stocks that are cheap both relative to underlying value.
The Question Of Liquidity
Small and cheap stocks tend to be fairly illiquid too.
In the stock market, buyers put a bid price on a stock, while sellers put an ask price. When a stock is very liquid -- i.e., there’s a high volume of buyers and sellers -- the spread tends to narrow. The bid/ask spread is very wide in illiquid stocks.
This has led professor Aswath Damodaran to contend that cheap small caps only outperform in theory, while in practice the outsized returns are eaten up by the spread cost. In other words, you’ll have to pay up to buy an illiquid stock, and you’ll have to accept a lower price when you sell.
However, well respected studies suggest just the opposite, that is, illiquid stocks are very well positioned for outsized returns. Stocks with a low average daily volume often remain cheap while they’re neglected by the market, but when good news arise -- see next topic -- investors pile up to buy the stock and, since there’s not enough sellers, the price shoots skywards.
Coiled Springs or The Good News Effect
People like lottery tickets. They buy stocks with fantastic narratives -- “the next Amazon”, or the firm that will disrupt a certain industry -- hoping to get rich quick. If the returns disappoint in the short term, though, they sell, and some stocks end up selling for ridiculously cheap prices relative to intrinsic value.
The stock prices of ugly, forgotten, hated stocks remain cheap for a reason: bad news surround them. They have an “ick” factor.
However, much like a thumb pressing a spring, good news slide the thumb off it and send the stock price skyward -- as we saw earlier, the liquidity factor plays an important role here too.
Given that penny stocks are subject to wild price movements due to low liquidity ant the good news effect, if you actually buy penny stocks -- cheap on an absolute dollar basis -- that are cheap relative to intrinsic value you could end up boosting your returns spectacularly.
My Cheap Stocks Sub-Strategy: How to Turbo Charge Your Portfolio
I searched for a long time to find an investment strategy that fit me well. I went through investing based on growth, to investing in cheap stocks relative to assets, and finally settled on a fantastic investment strategy. Actually, it's the best investment strategy that I'm aware of.
My criteria for finding a strategy was simple -- I wanted something that was easy to use and had a long proven record of extraordinarily high returns. That strategy turned out to be an asset-based strategy, Benjamin Graham's low price to NCAV strategy. No other strategy has been shown to offer up such mind-blowing returns again and again and again.
NCAV means net current asset value. Essentially, rather than taking all of the assets into account when measuring the equity of a firm, I only take the firm's current asset value into account and then subtract all liabilities from that figure to arrive at the firm's NCAV (sometimes called "net net value"). Mathematically:
Current Assets - [Total Liabilities + Preferred Shares] = NCAV
I typically invest in NCAV stocks trading at least 1/3 below NCAV that also have very little debt. How has this strategy worked out? Well, let's look at Tweedy Browne's stats:
When it comes to investing, buying cheap stocks based on absolute price is not enough -- you have to buy cheap stocks relative to some measure of value. Buying cheap stocks based on absolute price alone could wipe out your entire life savings while investing in cheap stocks relative to earnings, cash flow, or assets will help protect your downside while giving you the high probability chance to decimate the market.
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Article image (Creative Commons) by schizoform, edited by Net Net Hunter.
