The real danger of 'cheap' stocks

9:30 AM cheap, danger, stocks No Comments

| By MarketWatch

Investors who focus on nominal share price are at best wasting their time and at worst exposing themselves to huge risk.

Being a glutton for punishment, I try to be accessible to readers and fellow investors via Twitter and email.

And while the most common notes I receive are either about typos in my work or the stupidity of my investment decisions, another common message sent my way is in regards to "cheap" stocks.

I'm not talking about valuations here regarding price-to-earnings ratios or discounted cash flow analysis — I'm talking simply about whether a stock trades for $1 or $100 a share.

Unfortunately, investors who focus on nominal share price are at best wasting their time and at worst exposing themselves to huge risk.

Share price simply does not matter — the quality of your investment does. And the sad reality is that most stocks with a cheap share price tend to be of a lesser quality.

Here are the many reasons a focus on "cheap" stocks can be the most expensive mistake you ever make.

Some folks fall in love with the fast-paced world of penny stocks and microcaps, but the horror stories in this space are all too common. Consider the unscrupulous "stock tips" from celebrities like rapper 50 Cent on Twitter, or Notre Dame football legend Daniel "Rudy" Ruettiger charged by the SEC in a pump-and-dump scheme in 2011. And more recently, read about an August penny stock bust that involved a $140 million fraud ring across 35 countries. This is the crowd you're running with when you go for microcaps that trade on the pink sheets.

What about legit stocks on the NYSE that trade for $5 instead of 5 cents? Well, let's be honest… no stock trades for $5 because it's red hot. Stocks that are doing well go up and not down. Right now some of the biggest (by market capitalization) stocks in the single digits include the battered National Bank of Greece (NBG), barely break-even drugstore also-ran Rite Aid (RAD), and troubled chipmaker United Microelectronics (UMC). All have losses that top 50% across the last 10 years. Sure, they might go up from here… but will likely never reclaim past valuations.

People like to hold up the example of Apple (AAPL) with its return from the brink as the case of a turnaround play that made investors millions. But if you think geniuses like Steve Jobs and iconic companies like Apple are common among $5 stocks… well, think again. Turnaround stories more typically end up with an ending similar to the current narrative at BlackBerry (BBRY).

Consider Priceline.com (PCLN) traded for $600 a year ago and now trades for over $1,000 share for a 60% gain in 12 months. That included a 21% run in about three weeks this May. So don't tell me expensive stocks can't move big in short order.

Let's say you had $600 to invest a year ago and bought 240 shares of the Sirius XM (SIRI), the cult stock of bargain investors everywhere, for about $2.50 a share. It's now at $3.80, so you're sitting on 52% gains… not bad! But you also could have bought one share of Priceline at $600 — there's no minimum on shares, remember — and made over 60% gains instead.

Just to belabor this: 240 shares of SIRI x $2.50 per share = $600, and 1 share of PCLN at $600 per share = $600. And then, 240 share of SIRI x $3.80 = $912, and 1 share of PCLN at $1,000 = $1,000. Which is the better investment?

But what if you have less than $600 and want to invest? Well consider that only 12 stocks on the entire NYSE and Nasdaq (out of more than 4,300 issues) trade for more than $400 a share. That's a mere 0.3% of your investing options — hardly a big deal. And hey, only 150 stocks or so trade for $100 or higher. That's 3.5% of your investing options.

What if you simply just HAVE to buy a pricey stock like Priceline.com? Well, a host of online brokers often provide access to "fractional shares" … so you can buy a half a share or less instead.

So if you only have $100 to invest and if you have your heart set on Priceline.com, you can still buy it. But why in the world would you? Your broker may charge you fees as high as $10 a trade — and charge twice, mind you, since you get hit on both the purchase and the sale — so you need a 20% gain just to recoup the cost of trading.