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Posted 4/19/2001
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The Speculator
You can hit big with $5 stocks
Now for the delicious reward of gambling on cheap, risky stocks -- returns that top the markets, even on their best day. Here's why.
By Victor Niederhoffer and Laurel Kenner
After a market rally, the trees are greener, the sky is bluer and all our stocks look like Calpine (CPN, news, msgs).
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At times like this, with Nasdaq 100 futures up 35% from the low on April 4, it’s time to throw away the copies of "Tuesdays With Morrie," tear down the copy of "If " from your wall and tell the spouse to stop berating you for holding tech stocks.
Much as we appreciate Dr. Brett Steenbarger’s marvelous advice for coping with adversity and testing our grip on reality, it’s time to supplement him with some guidance from Norman Vincent Peale. Time to consider the beauty of Kasparov’s risky play. Time to save David Bronstein’s advice on creating a triple wall of protection around the king for a day when the Nasdaq ($COMPX) isn't up 150 points on a Fed rate cut, as it is as we write Wednesday morning.
An overriding theme of our recent pieces has been that during times of great pessimism, stocks are priced to yield extraordinary future returns of the sort offered to venture capitalists -- 40% to 50% being the usual allurement. Along these lines, we have advised the steady accumulation of risky stocks at propitious times in the market cycle.
Such a strategy has worked well for our high-volatility portfolio, which as of midday Wednesday is up 15% since its early March debut, compared with -2.8% for Nasdaq 100 futures and -0.3% for the S&P 500 futures over the same period. It also has been good for our original portfolio, which is up 15% on the year, better than the 13% and 4% respective losses for Nasdaq and S&P futures.
(Editors note: Our calculated returns may differ from those on our Recommendations page because of staggered purchase times and leverage recommendations.)
Today, we've had a stroke of luck. The market is having one of the greatest rallies of all time after a surprise 50-basis-point rate cut by the Federal Reserve. It's a good time to call it a day on all our stocks. We've been persistently bullish; now it's time to take profits.
Another look at risky stocks
It’s always a good time to learn more about risky stocks, and this week we revisited our previous work on the performance of stocks below $5 and $10. Again enlisting the aid of Tom Downing, research assistant at Value Line, we ascertained the performance of all stocks ranked for timeliness by Value Line, classified by price.
We like to use Value Line as a source because it provides a continuous weekly record, available at good libraries, of companies it covers going back as far as 50 years. The firm’s work is thus untarnished by the problem, common to academic and brokerage house studies, of retrospectively choosing a sample that would not have been available at the time.
Stocks below $5 are much in the news recently because many of them have shown extraordinary returns. In addition, Merrill Lynch recently published a widely reported study with negative conclusions on the performance of below-$5 tech stocks. A typical finding in the Merrill study was that there’s only a 3% chance that a stock selling below $10 will rebound to above $15 within a year. Of course, for a stock that sells at $7 to rise above $15 would mean a required return of more than 100%.
Regrettably, Merrill’s study gave no figures on the average performance of beaten-down tech stocks, nor any estimate of the variability of returns, nor, so far as we can tell, a prospective definition of “tech stock.”
For reasons like this, we often succumb to the “If it’s not invented here, it’s no good” syndrome. While we doubtless miss many great practical results with this bias, at least we can report our results in a scientific fashion and let other investigators build on our findings. That is the way knowledge advances in all scientific endeavors, and we hope our efforts will serve as a beacon for improving the level of knowledge in the analysis of stock prices.
In our current collaboration with Tom Downing, we looked at the performance of every company given any timeliness ranking by Value Line as of the end of each year from 1990 to 1999. We considered a total of 11,796 stocks.
Low price, high return
We then classified these into 10 categories based on the year-end price. The results are in accord with our previous conclusions on the merits of risky stocks. The companies with the lowest prices showed the highest returns.
For example, of the 434 instances where a stock was priced below $5 for one of the years studied, the average return the next year was 34%. For the 1,570 below-$10 instances, the average return was 22% vs. an average of 18% for all 11,796 in the sample.
Cheap stocks, great returns
Returns classified by price, 1990-1999
| Price at Year-End | Avg. % 1-Yr Chg | # of Observations | Standard Deviation |
| <$5 | 34 | 434 | 100% |
| <$10 | 22 | 1,560 | 85% |
| <$15 | 21 | 2,943 | 73% |
| All Stocks | 18 | 11,796 |
Scientists use the term “bifurcation” to describe forks in the road of development. Lungfish take to living on dry land; ancient Romans build aqueducts when local springs, wells and rivers become inadequate; primitive people start breeding animals instead of hunting them. The mathematical term is “discontinuity,” explains Jane Jacobs in her excellent book, "The Nature of Economies."
When something looks quite alluring, the path of least resistance is often to go with something less alluring, as the returns will be higher
Bifurcation also explains one of the problems with stock-picking systems, especially those that search for risky stocks: They tend to go haywire at just the wrong time, and to perform best when least expected. We refer to this tendency as the “principle of ever-changing cycles” and have written extensively about it. (Basically, it means that when something looks quite alluring, the path of least resistance is often to go with something less alluring, as the returns will be higher. Those who are interested in our ultimate source for this are encouraged to read Robert Bacon’s "The Secrets of Professional Turf Betting."
Longer is better
An interesting bifurcation emerged as we did our latest study. We found that when a company fell to a low price and stayed there for more than a year, its performance was much better than that of stocks that had more recently become cheap. In particular, companies that sold below $10 for two consecutive years returned 7 percentage points more in the next year than the corresponding companies in their price class that had been below $10 for only one year.
2 years are better than 1 for cheapies
| Stocks below $10 for 2+ Yrs | Stocks below $10 for 1 Yr | |
| % Chg in Price | 31 | 24 |
| # Observations | 1,066 | 504 |
| Standard Deviation | 88% | 99% |
As to why this split should work, we have a working hypothesis. The mere fact that a company is rated by Value Line for two consecutive years is in a sense a certification of the company’s viability. During that two-year period it is likely that the company has developed a line of defenses in the spirit of Bronstein (See our column, “Invest like a market grandmaster“), or more importantly, opportunities and prospects for gain that a company that has just recently fallen below the low-price barrier may not yet have achieved. For this reason, the conclusions of this study might best be limited to companies rated by Value Line, and should not be generalized to all low-price stocks.
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Too late the phalarope. It’s so much easier to discover fantastic results like this after the fact than prospectively. Nevertheless, in the spirit of intrepid endeavor and “no gain without pain” that sparked our revisit to this subject, we are going to step onto the slippery slope by making a recommendation.
There were two companies trading below $5 at both year-end 2000 and year-end 1999 that have not shown substantial appreciation so far this year, and in addition had recent insider buying. These are R.G.Barry (RGB, news, msgs), the leading maker of bathroom slippers, and Bombay (BBA, news, msgs), the furniture retailer. We hereby add them to our list. Considering where the market is, we would advise holding off at least a week before buying these stocks.
At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned any of the stocks mentioned in this column.
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.