Dumb Luck Investor: Betting On Those $1 Stocks

Maybe there are honest stockbrokers out there after all.

A close friend of mine told me the following story: His father had called him a few weeks back, interested in buying stock in UAL ( UALAQ). At roughly $1.50 a share, he thought it was a steal, simply refusing to believe that United Airlines would ever go out of business. (Were investors saying the same thing about Enron ( ENRNQ) or Arthur Andersen?)

The father had called his broker to buy 10,000 shares, but his broker said no. Too risky -- he wouldn't do it. As an alternative, he called his son, who placed the order for him in his own online account.

In fact, so enamored is my buddy with $1 stocks that he followed his father's logic and bought another 10,000 shares for himself. Unfortunately, things could get worse for United -- and did. Shares sank below 60 cents before perking back up toward $1. Needless to say, the 20,000 shares are now very much under water and, despite drastic changes within UAL and the airline industry, a major league rebound doesn't look likely anytime soon.

Such are the trials and tribulations of playing at the subterranean level of the market, where investors try and outsmart each other and the rest of Wall Street by betting on major comebacks of major losers. The logic is easy to understand: If a stock is trading at $1 or less, it shouldn't take much effort for it to get back to $2, doubling one's investment in no time at all. It worked for DaimlerChrysler ( DCX); it was a disaster for Enron. Who knows what might happen with United, WorldCom ( WCOEQ) and the like.

Such betting on dirt-cheap stocks offers interesting lessons for those willing to "gamble" rather than "invest." The major difference, say those who play this game, is in picking companies that are beaten down but are not down for the count.

For example, Internet stocks such as Webvan or Pets.com never had a prayer. As they fell apart, there were no legacy businesses or treasuries full of cash to prop them up. Consumers simply didn't depend on them as fundamental providers of goods or services; thus, they weren't essential to anyone for any specific thing.

Companies like UAL or WorldCom are far different, the argument goes. Would the federal government really allow such large employers to slide out of existence? (Well, actually, yes.) Don't these companies have so many customers that they could still operate within bankruptcy and eventually emerge from it? (Yes and no -- customers are more than happy to go with lower-cost options.)

And ultimately, doesn't their sheer size make them capable of staying afloat given mere mass alone? (Again, probably not. Arthur Andersen had thousands of employees and hundreds of large customers, and it closed its doors in a matter of months.)

Still, investors have short memories. For every Chrysler comeback, there are a hundred companies large and small that never make it. And even seemingly good news regarding a company's turnaround can merely end up being smoke and mirrors. WorldCom could be shaping up as a case in point.

Renamed MCI soon after the first of the year, WorldCom/MCI had swung to a steep loss in February after an accounting change began to straighten out its books. The company had posted a February loss of $332 million on revenue of $2.03 billion, though it was able to pinch out a March profit of $43 million on revenue of $2.1 billion.

It was encouraging news for investors, who were convinced that shares in the company could never simply wind up worthless -- especially as MCI anticipated emerging this fall from the nation's largest-ever bankruptcy. Still, despite a stock selling for pennies, investors should not overlook MCI's roots -- its massive debt burden and the $11 billion accounting scandal that had shaken the company to its core.

Granted, when a stock trades for a dollar or less, it's easy to roll the dice and forget the past. (In fact, MCI now says it had $3.3 billion in cash by the end of last month, a $500 million improvement on its January-end bank balance.) This does not translate, however, into a stock whose share price automatically rebounds to new highs.

Despite muted optimism among many existing shareholders given the modest March profit, even MCI has admitted that its own shares may ultimately be valueless. In a press release issued by MCI not that long ago, the company itself said, "MCI believes that when it emerges from bankruptcy proceedings, its existing WorldCom and Intermedia preferred stock and WorldCom group and MCI group tracking stock issues will have no value."

In other words, investors can take a chance on those poor, cheap, beaten-down stocks and hope for the best. But they shouldn't forget that, as with the rest of things in life, you still usually get what you pay for.

By Peter D. Henig, contributing writer and trading strategist at Optionetics.com.

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