Will cheap stocks make you rich, or destroy your portfolio?
There’s a sure bet in the stock market that almost nobody plays. It’s a bet that will virtually guarantee you large returns over the course of your life.
There’s another bet in the stock market, however, that’s sure to devastate your portfolio the longer you keep making it. Ironically, this fool’s game is far more popular with investors.
Both of these bets fall under the general strategy of buying cheap stocks but the specific sub-strategy that you employ will have a enormous impact on your long term results.
How to Devastate Your Portfolio With Cheap Stocks
When most investors think of cheap stocks they think of stocks like Elite Pharmaceutical, which trades over the counter at 37 cents per share, or Hudson City Bancorp, a stock that trades below $9 per share. Most people are instinctively attracted to buying 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 low priced stocks. When it comes to buying low, after all, you can’t get much cheaper than penny stocks, stocks trading below $1.
If you buy these these types of cheap stocks you probably see two major advantages to them. For one, since you’re paying so little for your stock there’s the perception that you just can’t lose. “How could I possibly lose on a stock that I’m buying for just $2?! I’m paying almost nothing for it!”
The other assumed benefit is the idea that cheap stocks such as Elite Pharmaceutical or Hudson City Bancorp have explosive profit potential. Many people think that it’s much easier for cheap stocks to double, triple, or quadruple in price compared to stocks priced at 20, 30, 50, or $100.
While it may or may not be true that cheap stocks have an easier time increasing in price, it’s definitely true that investor expectations about profiting through these types of cheap stocks is way out of line. If you want to make great returns by buying cheap stocks, you have to adjust your thinking.
The main problem with buying these types of cheap stocks — stocks trading for a low absolute dollar amount — is that you can actually lose quite a lot of money, even if they’re trading for just $2. The amount of money that you can lose is essentially the amount of money that you invested — $2 000, $5 000…. $100 000. If the company behind your $2 stock goes bankrupt then it doesn’t matter what the shares were priced at — you could still lose everything.
Do You Really Know What Cheap Stocks Are?
When my father first started looking for solid money managers I advised him to purchase stock in Warren Buffett (Trades, Portfolio)’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 B shares and stopped dead in his tracks. He just couldn’t get it out of his head that Berkshire Hathaway stock was extremely expensive.
Most people consider “cheap stocks” to be stocks that are trading for a low absolute dollar figure. My dad was no different — despite buying into the value investing philosophy. A lot of people look at the large cost per share of purchasing Berkshire Hathaway’s B shares and consider those shares expensive, while at the same time automatically assuming that stocks trading for below $1 are “cheap.”
Of course, the other way to think about cheap stocks is in terms of the price-value relationship on offer. This is exactly what I talk about when I mention cheap stocks to friends or those who signed up for free net net stock ideas.
If you nail this relationship then your portfolio will be well on its way towards high average yearly returns. In fact, picking a great strategy that exploits price-value discrepancies and then executing well on that strategy are two key factors in racking up returns that will make your friends jealous.
Cheap Stocks and the Essence of Value Investing
To get this point, it’s essential that you understand 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 is worth a certain amount of money, so are those individual pieces of the company.
A stock quote, on the other hand, is just the latest transaction price at which some of the company’s shares were exchanged. This price may or may not reflect the real world value — the value of the pieces of the company — that the shares represent. You wouldn’t think that your new Porsche 911 Turbo was worthless if someone offered you $10 for it, would you? Why would you think that your stock is worthless if it has been bid down to absurdly low levels?
Following this line of thinking, it should also be clearer why just buying based on a low absolute dollar amount can be so devastating. Ultimately, it doesn’t matter what the price of the shares are — it’s the relationship between the underlying business value and the price of the shares that matter. If you buy based on just a low absolute dollar amount and hype than you’d be completely ignoring the actual value of the shares — and there could ultimately be very little backing that share price…. and no solid reason for the shares to be worth even the low dollar amount that you paid for them.
Tiny packages can pack a powerful punch, but consistently high returns come from cheap stocks relative to value.
Recognizing that price is different from value and then buying when prices are well below underlying value is the essence of investing in cheap stocks.
Price can, and often does, swing around wildly in relation to value. Fortunately, price and value always seem to gravitate towards each other. That means that the price-value gap will close in time, no matter if it means the price rising to reflect value, the underlying value rising to reflect price, the stock price falling back down to earth, or the value falling so that it converges with the stock price.
While it’s true that you could buy overpriced shares in high quality companies and then wait for the value to catch up, this technique is far less lucrative, and far more risky, than buying cheap stocks. If you buy cheap stocks relative to value than if value falls your stocks are already undervalued so you are protected on the downside. More often than not, however, the price of the stock rises to reflect the value that it represents. In other words, since mean reversion is a fundamental law of the stock market, buying cheap stocks relative to value means protecting your downside while setting up a high probability chance that you’ll see large profits.
What I love about the stock market is that sometimes it causes people to do silly things. Stocks can be bid down to a small fraction of the real value they represent, making for fantastic buying opportunities. These are the type of cheap stocks that you want to buy.
Cheap Stocks Represent Systemic Weaknesses in Human Psychology
Why would anybody give up a stock for a fraction of what it’s worth? Simple: fear, myths, pain, and pessimism.
Human psychology is not set up to invest successfully in stocks — never mind cheap stocks. Out of all the activities that a guy can find himself doing — snowboarding, working in an intercultural workplace, dating a high maintenance woman, going to war — none compares to the emotional and psychological whirlwind that stock investing whips up.
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 — at best people, 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 fortunetellers.
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 and shift their buy and sell behaviour to correspond with them.
These stories, or myths that we buy into, can foretell doom and gloom, as well. Investors have assumed that Japanese stocks were a great way to loose money over the last 30 years, so have avoided the country altogether. Back in the depths of 2008/9 a major myth that crystallized in the mind of the investing public was that America was slipping back into another Great Depression. Since business would suffer a world of pain under those circumstances, stocks were liquidated by investors across the board.
Myths can develop on a much smaller scale, as well. Amazon could do no wrong over the last 5 years, pushing the stock up 400%. After the BP oil spill investors were certain the company would suffer terribly and possibly go bankrupt. The stock shot up nearly 60% by the end of that year.
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 can trigger 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.
Falling stock prices aren’t just terrifying — they can lead to potent psychological pain.
How are you going to tell your wife that you lost $20 000?
All that money you worked so hard for over the course of the last few years…. cut in half. Gone.
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.
How much pain can you take?
Sometimes a stock will lay at the bottom of the stock market, unloved. It found its way there after years of pathetic results leading to investor apathy. If investors don’t find promise in a stock, buyers can turn their nose up at the offer leading sellers to offer their shares up for cheaper and cheaper prices.
Those who bought into the stock at some point in the past may lose interest, and just want to cash out to invest in anything else. Often these investors will take what they can get for their holding, which can put further downward pressure on prices. For those schooled in the art of value investing, these type of cheap stocks can be a windfall.
Cheap Stocks Yield Spectacular Returns
You can take advantage of cheap stocks any number of ways — and each of these investment sub-strategies have spectacular returns.
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 (Trades, Portfolio), 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 (Trades, Portfolio)’s paper, The High Dividend Yield Return Advantage:
The real magic comes over time — when you consistently wrack up higher yields you end up beating the market by large amounts over time.
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 (Trades, Portfolio) has done with spectacular results.
Here’s one study that looks at UK companies:
As the dividend yield grows, so does the average yearly return.
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 Brown has uncovered in their paper, What Has Worked in Investing:
Low PE Stocks are a great way to thump the averages over time. Once again, cheap stocks win.
From 1957 to 1971 cheap stocks in terms of price relative to earnings vastly outperformed int he stock market.
Here’s how that same strategy worked in later decades, as shown in that same paper:
Cheap stocks in terms of price to earnings dominated in later decades, as well.
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 int he stock market. From Tweedy Brown’s What Has Worked In Investing:
Cheap stocks relative to cash flow have significantly outperformed.
As shown, 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 since value 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%.
Buying cheap stocks relative to equity has been a fantastic value investing strategy.
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.
And I should know — I used to invest based on earnings.
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 (Trades, Portfolio)’s stats:
Cheap stocks relative to NCAV offer the most proven high performance record of any strategy that I know of… and I’ve combed through a lot of strategies.
My own portfolio has done spectacularly well. On average, the annualized return of each of my stocks is 38%… so obviously my portfolio has made tremendous gains.
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.