A small movement in price could double or triple your money, but experts warn that playing the slot machines might be a safer bet.
"Most stocks that come to market aren't priced at $5 or under," says Rich Lowrie, senior vice president and investment consultant for McDonald Investments. "It's usually a sign of some kind of trouble. It could be that it came out as a $10 stock and then dropped to $5, or it might have been trading as high as $100 or more. A stock trading at $5 or under is a sign of damaged goods and is a definite buyer beware."
The low price lures a lot of investors because they think they are getting more for their money.
"I think the biggest mistake people make is confusing price and value," says Lowrie. "In other words, if something is trading at $4 a share, if there are only 10 cents a share of earnings, you are paying 40 times earnings for the company and that is an expensive price to pay. Conversely, a stock selling at $104 per share that is expected to earn $7 per share in earnings -- I consider that a cheaper stock. You are paying 15 times earnings, which is something better than the $4 stock."
The $104 stock is also going to give you a piece of what is likely to be a solid business with a long history of success in the market, thus lowering your risk.
"There is a similar appeal to playing slots," says Lowrie. "There is an emotional component that may compel people to approach stocks the same way. People say the $4 stock with 10 cents in earnings could double. But what's going to drive that? Are the earnings going to have to quadruple?
"The mistake people make is saying, 'What do I have to lose?' They think they are only losing $4. The real answer is, you have the same to lose on the $4 stock as anything else: 100 percent of your investment. One hundred percent is 100 percent. People usually don't just buy one $4 share, they could put in $10,000 and lose it all.
"For my $10,000, I'd rather buy the $100 stock that is going to provide a future stream of earnings of $700 per year."
If you are focused on managing risks and growing money, then you are better off focusing on quality stocks.
"There are people that make money on the small stocks, but they are kind of like lottery winners," says Lowrie. "The majority of people don't win. When you are buying low-priced stocks, there is typically some issue that makes them low-priced to begin with: They are choking on debt, on the verge of bankruptcy or maybe have huge lawsuits filed against them.
"They have to get through some serious issues in order for the investment to be viable."
The stocks are speculative, because investors can only guess at the outcome.
"People certainly want to be careful with these types of stocks and understand the difference between price and value," says Lowrie. "A lot of these stocks on a fundamental basis may be the most overvalued on the market because they don't have any earnings or very little earnings."
Many smaller stocks have been pounded by the bear market, losing 80 percent to 90 percent of their value. A 50 percent or 80 percent move will only recover a fraction of their value, but some investors are trying to ride the rebound.
"At some point, the fundamentals will determine where the stock will trade," says Lowrie. "In the long run, quality will win out." How to reach: McDonald Investments, (216) 443-2300
Sweating the small stuff
Small is where it's at.
Small stocks have attracted a lot of attention in a turbulent stock market, and in 2003, low-grade stocks outperformed high-grade stocks. Consider the following performance indicators from Merrill Lynch.
* C and D stocks outperformed A+ stocks by 55 percentage points in 2003; 1999 was the only year with a wider performance spread (73 percentage points) in the 18-year history of the Merrill Lynch indices.
* Despite their relative underperformance, A+ stocks (+26.4 percent) had their strongest performance since 1997. Cs and Ds (+80.9 percent) had their strongest performance since 1991.
* Low quality outperformance was broadbased in 2003. Low quality outperformed in eight of the 10 economic sectors tracked and within each size category.
* Higher quality stocks remain undervalued, and Merrill Lynch continues to emphasize quality as an investment theme.