Independent Investment Advice Since 1970

Stock Prices: Important and Nothing

By Timothy Lutts, Chief Investment Strategist and Editor of Cabot Stock of the Month

Price is Important

For almost everything we buy in life, price matters. From gasoline to automobiles, cheeseburgers to chateaubriand, we've learned that the lower the price, the better the deal.

There are some things you just can't get on sale, of course. I've never seen an advertised discount on college tuition (of which I've paid plenty), hip surgery (I'm not there yet), or property taxes (one of the certainties of life). But for most discretionary purchases, where retailers compete for your business, items are sometimes on sale, and if you can get them at a discount, you can save a lot of money.

The same is true in the stock market ... to some extent. You can pay full retail price by buying a stock as it's hitting all-time highs, or you can save by buying when the stock is temporarily on the discount table.

But how do you know what's a good discount?

You could use simple percentages, figuring that if a stock is selling 20% off its recent high it's probably a good deal. But that's a rather crude method, as it mistakenly treats all stocks the same ... and you know that an electric utility that's yielding 3% is not the same as a Chinese medical stock that came public last year.

A better guide to a stock's appropriate discount is the level of its 25-day and 50-day moving averages. When a stock that's in an uptrend has descended calmly to one of these levels, and paused there, the odds are good that the uptrend will resume, and that the stock will soon be selling at full "retail" price again.

I refer to these averages a lot in my writing, and I recommend that you note them whenever you're evaluating a stock. Also note that when a stock falls through one of these moving averages at high speed and/or on heavy volume, it's a bad sign, suggesting that the quality of the merchandise may be lower than previously perceived. And when perceptions about a company's value are changing for the worse in a big way, you should stop thinking about acquiring it on sale; you should shift your focus to stocks that are still in unquestioned uptrends.

There's a lot of merchandise in this stock market, and there's no need to get hung up on owning any one particular item.

Price Is Nothing

Getting back to price, in a big-picture sense. Oftentimes, after I've recommended a stock trading at 20, or 80, or even — like Intuitive Surgical — at 300, an investor will ask, "Can you recommend any low-priced stocks?"

And 99% of the time I say no. Here's why.

As a growth-stock investor, I tend to favor stocks that are going up. History shows those are the stocks most likely to be higher in the days and weeks ahead.

Low-priced stocks, contrarily, tend not to be going up. They tend to be going down. In fact, when you consider that most stocks come public in the magic range above 20, you realize that most stocks that are priced under 10 have lost more than half their value. They've disappointed investors, and some of those investors are just waiting to sell until their stock gets back to the price they paid for it, a phenomenon that tends to weigh on the stock.

Furthermore, low-priced stocks tend to be thinly traded, meaning institutions are not involved in a big way. As a growth stock investor who would rather see his stocks rise sooner than later, I like investing in stocks that institutions, with their billions of dollars, are pushing up.

The main reasons that investors like low-priced stocks are obvious. First, they think it will be easier to double their money in a two-dollar stock than in a 200-dollar stock. After all, the 2-dollar stock only has to go up 2 dollars! Trouble is, nine times out of ten it doesn't.

Second, they like to buy "round lots," 100 shares or 200 shares, or 1000 shares of a stock. They can afford 1000 shares of a 5-dollar stock, but they can't afford 1000 shares of a 200-dollar stock, and so they dismiss the 200-dollar stock as "too expensive."

Now, once upon a time, in the pre-computer era, it made sense to buy round lots. The fellow who purchased an "odd lot," perhaps 73 shares of a stock, had his order handled by the odd lot broker and didn't get quite as good a price as the round lot buyer.

But those days are gone. Mike Cintolo (editor of Cabot Top Ten Report), in fact, says that he almost never buys round lots. If he wants to allocate 10% of his portfolio in a stock, he invests exactly 10%, focusing on the dollar amounts and ignoring the number of shares.

The sad fact about these investors who focus on low-priced stocks is that they end up ignoring most of the best stocks! This year, for instance, the market's best performers include Apple, Baidu.com, Google, First Solar, Research in Motion, Suntech Power and the aforementioned Intuitive Surgical. The average price of those stocks is 287!

And any investor who limits his focus to stocks under 10 dollars is going to be ignoring most of the market's big winners.

A quick look at our database, interestingly, reveals this:

There are 2379 stocks trading under 10 dollars.

There are 3316 stocks trading in the sweet spot between 10 and 50. That's the neighborhood where stocks tend to come public, and that's the level that stocks are usually brought back down to when they split.

Above that, there are 573 stocks trading between 50 and 100.

Finally, there are 114 stocks trading at over 100 dollars per share. Those are the winners, the champions. Those stocks have reached that level by appreciating, and some of them are never coming down.

Berkshire Hathaway, for instance, under the control of ace value investor Warren Buffett, has never split. It now trades at an eye-popping 140,000 dollars per share. Following in the same mold (though not exactly touting the fact) are the uber-smart managers of Google, whose stock is now trading at 700.

My message. If you're investing for growth, you ignore those high-priced stocks at your peril. George Steinbrenner won six World Series by staffing his New York Yankees with high-priced talent. John Henry is now doing the same with the Boston Red Sox. And you can do the same with your own portfolio.

Contrarily, growth-oriented investors should generally ignore stocks trading under $10. Down there in the basement, the odds are generally against you.

But there is one exception, and it takes effect every December

Every year at this time, investors start considering how their portfolios are going to look at year-end, and they start considering the tax implications of their actions.

As a result, we see two big phenomena. First, we see "window-dressing." Professional money managers whose clients will get a snapshot view of the portfolio at year-end tend to load up on high-profile winners, driving those leaders to greater heights. And hedge funds that get paid based on their performance at year-end, will drive up the stocks they own, to help their results and put more money in their pockets. At the same time, investors who hold losers sell some of them to offset the tax liabilities from the winners they've sold during the year, thus driving those weak stocks even lower.

The result? By late December, some of these "losers" are oversold and ripe for a bounce. The best part of the bounce runs through January and into February. And the biggest bounces come from stocks trading under 10 dollars!

Every December, we publish a special report highlighting 10 low-priced stocks that we think have great bounce potential. These stocks can add a little spice to your portfolio in the month of January—and if you're really lucky, some of them could turn into long-term winners. But you shouldn't fall in love with them. These stocks were specially selected for this one particular job. I recommended that you buy several of them in late December, and sell after their bounce has run its course.

More Cabot investing advice
Receive investing tips via email every week. Sign up for our free e-newsletter, Cabot Wealth Advisory.
Yahoo Finance
Google Finance