Sunday, August 28, 2005

CHEAP STOCKS--LOOK OUT!

A regular reader has asked, Why do you keep buying more Google even at almost $300 per share when there are $5 stocks available?

The nominal price of a stock has almost nothing to do with whether the stock is cheap or not. Indeed, many low priced stocks are not cheap at all. The question is like asking how much will you pay for a piece of Apple Pie if the pie is cut into 2,000 pieces. I have written about this problem before in regard to SIRI. This satelite radio stock has over a billion shares outstanding. The price per share has a billion reasons to be low, but this does not make the shares cheap.

One of the methods used by a number of value investors is to ask if they would be willing to buy the whole company. If a $6 stock has one billion shares outstanding, it would cost $6 Billion dollars to buy the whole company. One can then compare what other company one could buy for $6 Billion. One might find a stock selling for $60 per share that only has 50 million shares outstanding. The total price of this company would be only half that of the $6 stock even though the per share price is 10 times as large. If the two companies were to make the exact same amount of profits, the $60 piece of pie would be 20 times as large for only 10 times the price.

Of course all pies and all companies are not the same size. When I talk about cheap stocks, I am talking about cheap in relation to ratios that can be compared. For example, if one stock sells at 10 times its annual earnings and another sells at 2o times its earnings, the first stock sells at half price based on this one measure.

There are always two sides to every trade. Therefore, if you sell a stock trading at 20 times earnings to buy a stock that trades at 10 times earnings, you are selling a stock that the market believes will grow faster than the stock you are buying. This last point is that there are no absolute answers to successful investing.

I personally tend to avoid stocks selling for less than $5 and I suggest that most other investors would be wise to avoid these stocks. On the other hand, I know a very wealthy person who has made huge returns on low priced stocks. He has studied this style of investing for about 60 years. He knows what he is doing. He is like the juggler who is willing to catch twirling knives. He has a lot of fun and makes a lot of money but a portion of what he makes is from law suites he files against bankrupted companies. Not a game most of us should play.

Buy stocks that are cheap realtive to other stocks. If you like growth stocks, no problem, buy growth stocks that are growing at a higher rate than others with the same cash flows. The list of reasonable stategies is long. Buying stocks because their nominal price is low is a poor strategy for most.

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