Are Cheap Stocks Under $1 Truly a Bargain?

Are cheap stocks under $1 investment worthy? Are they a steal or just surface-level cheap?

When most people look at cheap stocks priced under $1, they probably see an easy-to-assess investment choice. Because of their low capital requirements, they can buy more of these stocks, doing so with the expectation that the stock price can go only one way — up!

Their standard argument for buying cheap stocks under $1 is that a small price increase can turn into a large profit. After all, a 40-cent stock only needs to rise to 80 cents to double the investment, and that seems simpler than finding and investing in $20 or $50 stocks. They also reason that the prices of these cheap stocks under $1 can’t go down any further than its current low price, thus making it difficult to lose money.

However, as net net investors, we know that this is flawed thinking. A company’s prospects have to improve tremendously for a very cheap stock to increase at such a rate. A $0.40 move on a low-priced cheap stock is not the same thing as on a higher-priced stock. The value of the dollar should not be used as a measure, rather a percentage should be used in order to calculate the returns instead. Furthermore, we know that when we invest a dollar, the worst-case scenario is for the price of the stock to drop to zero. Thus, as much as it is just a dollar, we are losing 100 percent of our principal.

Investing in cheap stocks under $1 requires extra caution and care. They are highly prone to volatility and speculation. Their low trading prices attract investors looking for a means to speculate and gamble their money away. Often, it is tougher to find credible information on these companies’ performance and history. Some of them are not even required to file with the Securities and Exchange Commission (SEC). It’s hard to know whether they are highly overleveraged, headed for bankruptcy, or engaged in fraud. Without this knowledge, investors cannot determine the company’s financial position or the ability of its management team. What this usually means for value investors is the opposite of what they seek — low-priced stocks come with high risk.

Actual Price of a Company

Before we determine whether cheap stocks under $1 are a bargain, we need to first examine the actual value of the company, as the cheap stock price alone does not represent a company’s actual worth. Instead, market capitalization is a more accurate measure to look at, since it represents the true price as perceived by the overall market.

For instance, Apple has a stock price of $172 per share with a market cap of $815 billion, while Amazon has a higher stock price of $1,620 but a lower market cap of $796 billion. On first glance, Amazon looks more expensive than Apple because its stock is nearly nine times higher. But in fact, Apple is more valuable than Amazon in terms of actual dollar value. Comparing the two companies solely by looking at their stock prices does not give a true representation of the real price of the entire company.

Market capitalization is calculated by multiplying a company's outstanding shares by the current market price of one share. Since a company is represented by a number of shares, multiplying this with the per share price represents the total dollar value of the company. “Outstanding shares” refers to a company's stock currently held by all its shareholders, including restricted shares owned by the company’s officers and insiders and share blocks held by institutional investors. The formula to calculate market capitalization is:

Market Capitalization = Current Market Price (per share) X Total Number of Outstanding Shares

It doesn’t matter if the $0.50 stock has 200 shares outstanding or a $1 stock has 100 shares outstanding — both companies have an equal market capitalization of $100. It does not make the $0.50 stock with 200 shares any cheaper or attractive; the dollar value of the company is the same. If you are spending $50 to purchase either of these stocks, you will own 100 shares and 50 shares respectively, but in either scenario, you still own 50% of each company. The number of shares held does not mean that you own more of the company. Your total investment account, and not how many shares you own, determines your wealth.

Remember, You Are Buying a Part of a Business

However, determining the market capitalization is not enough by itself to justify a purchase of cheap stocks under $1 since it does not give us any other information. Investors who focus solely on very cheap stock prices neglect the key fact that stocks cannot be determined by price alone but rather by their value. Investors need to remember that when they are buying a share of the company, they are buying a part of a business, not just a piece of paper. It is important to keep a business owner’s mindset, as it is a distinct characteristic of a net net investor.

Simply put, if there are two stocks in front of you now, with the first being priced at $0.60 per share, with 300 shares outstanding, but has an actual value of $1, while the second is priced at $0.70 per share, with 400 shares outstanding, with an actual value of $0.80, which will you choose? A rational investor will pick the first stock as it has the greatest discount between price and value. The first stock sells at a 40% discount, while the second stock sells at 12.5% discount. Buying a stock at a discount provides us with a margin of safety and aids us in eliminating mistakes if we are wrong.

‘Price Is What You Pay. Value Is What You Get’

Warren Buffett once famously said, “Price is what you pay. Value is what you get.” This resonates with our example above. Our main focus should be on finding net net stocks with the largest disparity between price and value, rather than just finding “cheap” stocks. Buying cheap stocks under $1 doesn’t mean it’s a bargain. A cheap stock sold at $0.90 may still be overvalued if the business is only worth $0.05, with negative earnings for the past five years. Will you pay for something that sells at 45 times its net worth? Will you pay for a company that has not earned a single cent for the past five years?

This example may seem exaggerated and absurd, but if you look around, you will find many companies that are trading at such ridiculous prices. Such a wide price and value mismatch would surprise you. For net net investors, the greater the gap mismatch, the more excited we should get as we are better able to take advantage of the situation and attain a higher return.

Importance of Price

Nonetheless, price does play a role when it comes to being listed on the exchange. For stocks on the American Stock Exchange (AMEX) or Nasdaq, once the price falls below $1, they run the risk of being delisted from the main exchange. As a result, cheap stocks under $1 typically trade on the Pink Sheets or FINRA’s OTC Bulletin Board (OTCBB).

Usually, when the market capitalization is too small, we also run into difficulties such as illiquidity and insufficient volume in the market. These are interlinked to further problems like market manipulation and wide bid-ask spread. Thus, there is still a need to take price into account and ensure that minimum market capitalization is met.

Furthermore, for exchanges such as the Singapore Exchange (SGX), there is also a minimum requirement of purchasing at least 100 shares. For investors with smaller portfolios, price creates a barrier of entry as they must have substantial capital available to invest.

Buy Bargain Stocks, Not Cheap Stocks

As net net investors, we love small cap stocks. These companies have a proven track record of providing much higher returns statistically than larger companies. That being said, we need to balance our desire for loading our portfolio with low market capitalization stocks with finding those that meet a minimum market capitalization threshold. This will reduce the probability of being delisted, while at the same time, the lack of ready and willing stock investors provides us with the chance of higher returns.

As Walter Schloss once said, “Basically, we try to buy value expressed in the differential between its price and what we think it's worth.” This is the mantra that net net investors live by.

It is very important to keep in mind that the price of a stock is merely a number that determines how much we need to pay in order to own a slice of the company. No matter how low the price of the stock is, even if it falls under $1 and seemingly is a cheap bargain, that does not make it a good investment. Only if the price is trading well below its value should we pull the trigger and make a purchase.

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Article Author: Jialin Chua

Article image (Creative Commons) by H.L.I.T., edited by Net Net Hunter.