Why You Want To Avoid Cheaply-Price Stocks
If I had a dollar for every time someone told me they wished they’d bought XYZ at just a couple of dollars… Well, I’d probably be able to buy a new iPhone. We’ve all been there before and had what I call the coulda, woulda, shoulda’s on a stock that is now trading for hundreds of dollars. It’s human psychology to think that a stock trading at $3 per share right now could easily double or triple, but in reality it is a loser’s game. Depending on who you ask and their definition, a Penny Stock is any stock trading from a fraction of a cent up to as high as $5. Personally, I highly scrutinize any stock trading for under $10 per share. I started to do a study on penny stocks and their ultimate outcome, but fortunately, the University of West Georgia dug into this back in 2001. Here is an excerpt from their study:
In the sample of 154 firms that this study is based on, the total investments of the common stockholders of 93 firms were totally wiped out. Overall, these shareholders suffered an average loss of around 70 percent.
There are probably better studies and more recent studies out there that I could focus on in the future, but I wanted to make a quick comment about this topic as the stock market takes off on another tear. People often ask me about a stock trading in the single dollars and how they think they can make a lot of money in it. This is a fallacy. There is only one measure of the size of a company that you want to look at: MARKET CAP. This is simply the price of the stock multiplied by the number of shares outstanding. A company trading for $40 could be a larger company than a company trading for $80 per share quite easily. If there are many more shares outstanding, that makes the company more valuable when you multiply that share supply by their current price.
Another fallacy is the notion that a stock can only go so low and can eventually rebound so long as they don’t go out of business. This is also false. As a stock approaches penny stock status, that stock can do something called a reverse split. Basically, the stock price can instantly double or triple as investors get a reduction in shares they own proportionately. If your stock is worth $2 and you have 100 shares, your 100 shares could turn into 25 shares valued at $8 in a 1-4 reverse split. The value of the company doesn’t change, but the price of a stock does. This is usually a bearish sign for a company. The flip side of this is what is known as a traditional stock split. Look no further than Apple stock. It’s been a very large uptrend over the past three decades, but it would be worth several thousand dollars per share today if the stock had never split.
So you want the next Apple, right? That’s the point of buying those “cheap” stocks, isn’t it? Consider this, if you bought Apple stock on March 1, 2019 and held it until today, December 22, 2023, you would have QUADRUPLED your money. What if you’d have bought Nvidia in this same timeframe? How much would you be up? TEN TIMES your initial investment! And we’re not talking about all those stocks in the 90s that seemingly have blown up had you bought them then. We’re talking about just 2019 in this example. Is this the norm? No, but you’re not going to lose all your money in Apple. In fact, Warren Buffet has himself said that he has a ridiculously large percentage of his portfolio in Apple. While I think this is a very bad idea, I’ll save that discussion for another day.
So you want the next Apple or Nvidia? Why don’t you just buy the current Apple or Nvidia instead? Just be patient and wait for a price correction so you don’t overpay for them…
