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Posted 3/1/2001
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The Speculator
Cheap stocks can be worth the risk
Why go in search of danger? Because that's where the money is. Two examples: Chart Industries and Iomega sell for under $4 and have lots of upside potential.
By Victor Niederhoffer and Laurel Kenner
I must go and meet with danger there; or it will seek me in another place, and find me worse provided.
-- William Shakespeare, "Henry IV, Part 2"
Risk is the topic of the day, whether in the market as we wait for the Fed to act, or in life as we decide where to go after our firm finishes downsizing.
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The topic is so big that even the West of Louis L'Amour falls short of its boundaries. The L'Amour story "Trap of Gold," however, applies just as well outside the territory. In it, he describes a miner taking gold out of an outcropping by hand. For each additional ounce of gold he removes, the chances that the mountain will fall on him increase.
We seem to be in a similar situation with the market. The longer we stay in, the greater the chance that we will be there for one of those interest-rate cuts that turn stocks to gold. Unfortunately, staying in means exposure to the market's disappointment should the hoped-for cuts fail to come.
To try to say something helpful about a subject as vast as risk is like building a bridge across an ocean. Since it is at the core of fields as diverse as architecture, board games, cognitive psychology, construction, epidemiology, gambling, insurance, mountain climbing and statistical decision theory, you would think there would be a few common threads.
We therefore turn for guidance once more to the wisest man of all, Shakespeare. When we find ourselves in fathomless seas, his wisdom is what the mariner's compass was to 15th-century sailors.
In "The Merchant of Venice," Shakespeare anticipated the findings of modern academics by some 400 years: "Men that hazard all do it in hope of fair advantage." In other words, the greater the risk, the higher the required return.
Thus fortified, we will venture to employ our own humble talent, counting, to enlighten in a few small areas. Every oak was once an acorn, and although we do not have the masterful sweep of the aforementioned sages, perhaps our contributions will not be without profit to our devoted readers.
Reading the risks
We are constantly on the lookout for stocks for which the market's perception of risk is greater than warranted. Our search has led us to the far corners of the stock exchanges, from high P/E stocks (" Why high P/E stocks are good for you") in the Nasdaq 100 ($NDX.X) to unprofitable midcaps ("Place a bet on strategic long-shot investing").
On Oct. 12, we looked at NYSE stocks that fell from above $10 to below $5 ("Big stocks under $5: real bargains?"). Finding an embarrassment of riches -- 57 stocks that fit the bill -- we threw out those without recent insider buying. The resulting portfolio of 22 stocks rose 13% through this Monday, soundly beating the 1.7% gain in the NYSE Composite Index ($NYA.X).
Today, we're refining and expanding our study of below-$5 stocks. First, we looked at data back to 1989, to make sure that we had not been chasing a wild goose rather than a golden fleece. More important, we used Value Line's timeliness rankings to screen the results, to determine whether they might provide a way to sharpen an investor's aim.
With invaluable help from Tom Downing, chief assistant to Value Line's venerable research chairman, Sam Eisenstadt, we employed a simple procedure. As of the end of each year, we looked through Value Line's summary and index, a 25-page compilation of information about each of the 1,550 companies Value Line follows.
We chose all the companies that sold below $5 at the end of each of the years in the period and calculated their one-year performance. We then compared the results to the total Value Line universe.
The below-$5 stocks outperformed the Value Line universe by 10 percentage points -- 22% vs. 12%.
We then classified the below-$5 stocks by their Value Line timeliness numbers. The rankings did provide valuable information. No companies selling below $5 had a "1" ranking, but 30 were ranked "2" and 224 were ranked "3." These "2" and "3" companies appreciated 42%, on average -- 30 percentage points more than the average of all stocks in the Value Line universe and 20 percentage points more than the average for all low-priced stocks.
A summary of the results follows:
One-Year Performance of All Stocks Covered by Value Line
Classified by Price at Year-End (1989-2000)
| Price | # of observations | % Price chng. | Standard deviation |
| Below 5 | 491 | 22 | 90% |
| All | 15,500 | 12 | 55% |
Average One-Year Return of All Stocks Below 5 in Price
Classified by Value Line Timeliness Rank
| Rank | # of Stocks | Return | Variability |
| 2 | 30 | 56% | 105 |
| 3 | 224 | 28% | 88 |
| 4 | 151 | 13% | 85 |
| 5 | 86 | 32% | 146 |
| All | 15,500 | 12% | 55 |
We also looked at stocks selling between $5 and $10, but found no difference in their performance and that of the broad Value Line universe.
The relations have held up so far this year. The 150 companies with the lowest prices in the Value Line universe as of year-end rose an average of 37% through Feb. 26, vs. an average gain of 4% for the 1,550 companies in the sample.
Why does buying cheap work?
The question is why this happens. Downing, on whose fine work we heavily relied for this study, said he doesn't know why it works. "Perhaps it is a manifestation of some other anomaly, like low price-to-book, or low-cap, although these did not perform so well during the study window. Excellent performance this year is certainly related to the January effect, whereby low-cap risky stocks seem to do better." (They hadn't in the preceding several years.)
Our friend and reader Tim Melvin, a broker for Baker Weeks in Baltimore, offered a more direct explanation. "Most of these stocks have fallen dramatically some time in the last year or two, or are in some hopelessly out-of-favor industry group," he wrote. "The Value Line timeliness rankings, based on earnings and price movements, show these out-of-favor companies are in the process of recovery. As you would say, Vic, they have a long way to go to retrace the elephantine tracks of their decline."
The next question is when buying cheap stocks works best. We have the monthly data and can report that most of the superior performance is concentrated in November, December, January and February. The superior performance of below-$5 stocks ranked Group 2, for example, begins at 3% after two months, goes up to 7% after five months and then stays relatively constant through the 10th month, adding a full 6 percentage points in the last two months.
Thus at last we come to the always-present query of our editor: "What does this have to do with how readers can make money right now?"
Names worth noting
Value Line's year-end issue had just six stocks that are candidates for buying under this strategy. Of those, OMI Corp. (OMM, news, msgs) was the first sub-$5 stock ever to receive a "1" ranking for timeliness. It is up 14% year to date.
Five below-$5 stocks were ranked "2" -- Galey & Lord (GNL, news, msgs), Read-Rite (RDRT, news, msgs), Iomega (IOM, news, msgs), Chart Industries (CTI, news, msgs) and Western Digital (WDC, news, msgs). Regrettably, the average appreciation for these stocks is 48% in just two months. While we have no evidence that, for systems like this at this time of year, stocks with lagging performance do better than those with superior performance, we are psychologically unable to buy or consequently to recommend such stocks.
However, we note that two of the "2"-ranked stocks -- Iomega and Chart Industries -- have not yet shown inordinate appreciation. Better yet, they both have recent insider buying. We hereby recommend them.
Since it's the beginning of the month, and because a sort of stability was reached when the Nasdaq 100 futures closed below 2000 on Tuesday, and because the CBOE Volatility Index ($VIX.X) is hovering around 30% as we write, we also recommend increasing the exposure of the account to 150% of equity, through margin borrowing.
• Don't lose your faith in the tech sector, 2/22/01
• For love of money: Casanova and the speculators, 2/14/01
• Roll the dice on a money-losing company, 2/8/01
more...
The sex-to-Shakespeare ratio
In one of his more baroque statistical forays, Vic once counted the number of books published on sex compared with books on Shakespeare and found an amazing positive correlation between the resulting ratio and market performance. The more the books on sex in relation to tomes on Shakespeare, the better the market performance.
On Tuesday, Vic's brother, Roy, whose fund had the best record in managed futures trading last year, noted an example of the sex-to-Shakespeare ratio in action: Intimate Brands (IBI, news, msgs), purveyor of Victoria's Secret lingerie (and 84% owned by The Limited), reported terrible earnings and warned of a "challenging" three quarters ahead. Apparently, both women and men are taking less risk nowadays. And therein lies an opportunity.
At the time of publication, Victor Niederhoffer owned the following equities mentioned in this article: Chart Industries. Laurel Kenner owned none of the equities mentioned in this article.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.