With Cheap Stocks, You May Get What You Pay For
Digital Sound Corp. seemingly had plenty going for it when the Carpinteria-based company went public in February 1990.
Although it was a young company, its electronic voice-mail systems were well-respected in the telecommunications industry and already counted such discerning customers as Pacific Bell.
The voice-mail business was clearly going to boom, so there was little reason to question Digital’s growth prospects. And the underwriter of its initial stock offering was a marquee name on Wall Street: the venerable firm of Goldman, Sachs & Co.
Yet as an investment, Digital’s stock quickly bombed, falling from $8.50 at the offering price to $1.50 by the end of 1990.
Worse, any poor souls who have held on to the shares since then, betting that management would eventually turn things around, now hold stock worth a mere 72 cents at Friday’s closing price on Nasdaq.
So much for the merits of long-term investing.
The lesson here is a good one to mull over, with many small-company stocks having been trashed over the last nine months and now selling at prices that seem to be extraordinarily cheap--and crying out to bargain hunters.
Cheap they may be, at least in dollar terms. But the sober truth is, just because a stock has plummeted doesn’t mean it has to rise again. More often than Wall Street likes to admit, beaten-down small-company stocks never come back.
Randall Roeing, editor of the Low-Priced Stock Survey newsletter in Hammond, Ind., notes that investors who try to pick among stocks that have fallen dramatically tend to think of themselves as “bottom-fishers.”
“Well, I’ve bottom-fished a lot in my day, and the only thing I get is catfish or carp--and I don’t like either one of them,” he says.
The point being, you often get what you pay for when buying decimated stocks that sell for the price of a fast-food lunch, or less: unappealing businesses with lousy prospects.
To be sure, it is quite possible to make money buying the down-and-out. Kmart stock fell as low as $5.75 in 1996 when many investors mistook it for a bankrupt-to-be. The price now: $13, a 126% return if you bought at the low.
In the market crash of 1987 and its immediate aftermath, investors treated many stocks with irrational hostility. BankAmerica was a $7 stock by the end of 1987; you have to pay about 15 times that price to get a single share now.
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The distinction that must be made, however, is between buying depressed shares of large companies (troubled or solid) that already have an established constituency on Wall Street, versus buying depressed shares of struggling small companies about which hardly anyone cares.
The question to ask about the latter stocks is, will anyone ever care? Because “unless other people buy them, it may not matter what they’re intrinsically worth,” says James B. Cloonan, chairman of the American Assn. of Individual Investors in Chicago and a longtime student of smaller stocks.
Think about what happens when small-company stocks sink in price. They tend to fall off the radar screens of brokerage analysts, if they were ever on those screens to begin with. Meanwhile, relatively few institutional investors prospect among shares of the smallest of companies because they can’t justify the time and effort needed to research them.
In short, there may be no one serving as a genuine advocate for a “cheap” small-company stock, and not much hope of any fan club developing soon.
That leaves an individual who tries to buy or sell these stocks totally at the mercy of the savvy dealers who trade them on a stock exchange or on the Nasdaq market. And on Nasdaq, in particular, the dealer “bid” and “asked” price spreads can be wide enough to drive a herd of cattle through.
Do the math: If the current dealer bid for a stock is $5 and the dealer asked price is $5.50, and you pay the $5.50, the stock must rise 10% just for you to break even.
Of course, if a business grows over time it should attract more investors to its stock. But among the thousands of small, publicly traded firms out there, many simply are not, and never will be, true growth companies--able to post the uninterrupted sales and earnings gains that Wall Street craves.
By definition, after all, only a handful of companies reach the level of success of a Microsoft or a McDonald’s. The vast majority of companies rarely are in such control of their own destinies.
Digital Sound, for example, managed to boost sales from $23.3 million in 1993 to $31.7 million in 1994 and earn $2.5 million in ‘94, giving its stock a brief lift. But sales slid again in 1995 and were flat last year, and the company lost money in both ’95 and ’96.
It’s not as if voice-mail is a dying industry. But it may as well be, if you’ve been a Digital shareholder.
Yet a small company doesn’t even have to lose money for its stock to stay in the doghouse for long periods.
Ag Services of America, an Iowa-based supplier of seed, fertilizer and other supplies to farmers, posted a 74% sales rise between 1993 and 1995, from $66 million to $115 million. Earnings grew a respectable 53% in that period.
But that wasn’t enough to get noticed: Ag Services’ stock traded mostly between $7 and $10 from 1993 through 1995, before finally getting some attention last year. Current price on the New York Stock Exchange: $15.625.
Many investors understandably become frustrated waiting for small stocks like Ag Services to come to life. And certainly over the last three years the market’s message has been that bigger is better, anyway: Blue-chip stocks handily outperformed smaller stocks in 1994, 1995 and 1996, and that trend shows no sign of shifting.
“I don’t understand what’s going on with small-cap [capitalization] stocks,” says an exasperated Jeff Petherick, co-manager of the Loomis Sayles Small Cap stock mutual fund in Boston. “On a historical basis, small stocks probably are trading at their lowest valuations [relative to earnings] of the last 10 years,” he argues.
“Eventually we’re going to have a huge bounce in these stocks.”
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No argument there: Someday, undoubtedly, the small-stock market will again have its day in the sun, and many of the stocks will come roaring back. On at least a temporary basis, even some issues that don’t deserve to rebound probably will.
But if your game is merely buying depressed smaller issues with little regard to the companies’ fundamentals--and without doing the admittedly difficult and time-intensive homework needed to truly understand the businesses--then you are speculating, not investing. Good luck.
“You might be able to get a trade out of some of these, but I wouldn’t be thinking about them as long-term holdings,” Roeing says.
Putting together a winning portfolio of “cheap” small-company stocks at a time like this may seem like shooting fish in a barrel, Roeing says, but “it’s more like picking an apple out of a vat of boiling oil.”
