Investing in low-priced stocks can be highly profitable for investors willing to do their homework. Often, a number of low-priced stocks are on the brink of benefiting from operational turnarounds. However, the single-digit stock universe is also filled with potholes and potential land mines to avoid. Our experience in picking low-priced stocks has helped us identify four myths that once broken should improve your overall investing experience and, more importantly, your returns. Myth: Low-priced stocks are cheap While it's true that some low-priced stocks may be considered inexpensive from a reasonable valuation standpoint, many are wildly expensive. In other words, the stock price itself is not a factor in gauging a stock's "cheapness" relative to its peers. This all-too-common mistake of confusing the price of a stock with valuation has led many investors over the past two years to buy fallen technology and telecommunications shares. Investors believe that the drop in stock price -- sometimes as much as 99% -- is a buying opportunity. Unfortunately, as investors in Lucent ( LU), Applied Micro Circuits ( AMCC) and Nortel ( NT) can attest, this practice can be a vicious destroyer of capital. Sure, these stocks have nosedived from their peeks set during the Internet and telecommunications bubble of the late 1990s. But on an earnings basis -- for the companies that actually have earnings -- most of these stocks remain expensive on traditional valuation metrics, regardless of their single-digit prices. To avoid this trap, we constantly run screens in search of stocks that are both low-priced as well as reasonably valued. Over the past 20 months, we have selected dozens of double-digit percentage winners that met our criteria of being reasonably valued for the long-term investor. For example, we added shares of on-demand software company RightNow Technologies ( RNOW) when it was trading in the single digits at just two times sales while its closest competitor, Salesforce.com ( CRM), was trading at nearly five times sales.
Myth: The mega-cap winners of the next decade are likely trading in the single digits today According to Investor's Business Daily, most stocks that make large percentage moves usually start their ascent above the $15 threshold. Ignoring splits, which alters the perception of a stock's price history, Cisco ( CSCO) came public at $18 a share and never traded in the single digits. Nor did Wal-Mart ( WMT) for that matter, or countless other long-term winners of the past decade. In fact, most of the biggest percentage gainers over time have gone public above $10 a share and never looked back. This is an important myth to recognize because unrealistic expectations can cause lapses in near-term judgment. A quarter or two of strong gains in a software stock is not an automatic signal that you own the next Microsoft ( MSFT). And sometimes the most opportune time to take profits in a stock that has moved higher is when its strength can be attributed to unrealistic expectations about future period earnings and sales growth. So remember, the odds that you are holding the next Google ( GOOG) or Whole Foods ( WFMI) are slim. Taking some of your profits by selling into price surges is the only sure way to win when trading low-priced stocks. Myth: You can make big money buying and holding a basket of low-priced stocks Apropos to the previous myth about low-priced stocks eventually becoming mega-cap winners, it is not prudent to buy a basket of low-priced stocks expecting that in five years you'll have at least one big winner. The low-priced stock universe is loaded with the shares of bad companies that have fallen for specific reasons, and many may be stuck in the single digits for years to come. In addition, investing only in low-priced stocks goes against the simple principle of diversification. Investors should balance their equity holdings between low-priced speculative stocks, solid blue chips and fixed-income instruments.
So another key element to reaping big returns in low-priced stocks is to remember one axiom: The rule is not buy and hold, but buy and do homework. Our research process includes reading company news releases, listening to earnings conference calls, scouring the Web for news articles that may impact our holdings, and speaking with companies' management. Building a knowledge base on each position enables us to act rapidly when material news does develop. Myth: Volatility is your enemy Keep in mind that while volatility can be tough on your stomach, it can also be the path to strong returns in a stock position. You have to be mentally prepared for wild swings in your holdings in order to stay the course; nothing is more destructive than panicking and selling a position too soon. A big part of this preparation is knowing the fundamental landscape surrounding a position. This includes having a firm conviction about why you own a stock and foreseeing the possible threats that could cause you to change your opinion. For example, we own Allscripts ( MDRX) in the model portfolio and have watched shares double over the past 18 months. However, news of a stock offering to fund an acquisition has sent shares on a roller-coaster ride of late. The stock traded near $19 in early September 2005, but fell to a low of $13 a share in December, only to rally back to a 52-week high of $19.83 on March 2. While these wild price swings created multiple opportunities to panic and bail out of a solid holding, we have instead held our course. We initiated the Allscripts position on Oct. 20, 2004, as a play on growing demand for medical information technology. President Bush has been an outspoken proponent of digitizing patient records and improving technology in medical facilities, and Allscripts' products position the company to benefit. So the volatility in the stock was unrelated to our long-term bullish view on the medical information technology business and was nothing more than a short-term aberration in an otherwise solid long-term trend. The bottom line: There's plenty of money to be made in low-priced stocks. However, there are many traps that can curtail your efforts. Be mindful of these myths, and you should be on your way to better returns.