With Added Risks, Avoid Low-Priced Stocks
To some investors, the idea of owning 1,000 shares of a $5 stock sounds a lot better than buying 50 shares of a $100 issue.
Investors are usually better off buying higher-priced stocks, which are really a proxy for higher-quality companies.
The phrase "you get what you pay for" applies in most things in life, as well as in the world of stocks. There's a reason why a Lexus commands a larger price tag than a Ford Focus.
Also, you should realize that low-priced stocks have certain risks.
Many of them are thinly traded, making them prone to wild swings.
Motion systems maker Allied Motion Technology has a 50-day average volume of about 8,500 shares.
With such light interest, the bid-ask spread can be significantly bigger than a more-liquid counterpart.
And the stock can be more easily manipulated by a few large orders.
Making an informed decision on lower-priced stocks can be tougher. Many of these are companies that don't have long track records or much background written about them.
For some, you can't find analyst coverage or earnings estimates. Some are so small or obscure, they don't even have their own Web site.
Then there's something else lacking in cheap stocks -- institutional ownership. Stocks need mutual funds, pension funds and other major investors to support them and bid them higher.
Armed with billions of dollars, these professional investors tend to pass over cheap stocks for higher-priced, better-quality merchandise.
Professionals also can't buy big positions in lower-priced issues without running up the stock's price.
Lastly, a company's share price may be cheap for a reason. It's business may be heading south.
Autobytel, an online provider of car ads, lost money in fiscal 2005 and '06. It's slated to repeat that this year and next. The stock is now around 3.50 a share, well off its record high of 58 back in 1999.
Instead of trying to get a bargain, investors should focus on stocks priced at 15 or higher.
Eliminate the added risks of cheap stocks by investing in liquid issues -- those with average daily trading volumes of at least 100,000 shares.
Your buy candidates should also have a strong record of earnings and sales growth.
And, of course, you want to see that the big guns are with you. Seek stocks with solid institutional ownership.
Bear in mind that a low-priced stock is not necessarily the same thing as what a value investor would consider cheap.
Stocks trading at relatively low price-to-earnings ratios are considered good bets by value investors.
But research shows market winners are usually at high valuations, even before they make their most impressive run-ups.