Cheap Can Cost You

“Many have been ruined by buying good pennyworths [bargains].” – Benjamin Franklin

One of the most common mistakes made by “bargain-hunting” investors is thinking that low-priced stocks offer greater opportunities than those selling at higher prices.

On the surface, that kind of thinking makes sense. After all, if you buy a $5 stock and it goes up a measly $1 or $2, you get a lot more “bang for your buck” than if a $50 stock goes up by the same amount. Right?

Of course, that’s right. A $5 stock that goes up $2 has posted a 40% gain. That’s clearly better than the paltry 4% gain you realize when a $50 stock goes up the same $2. But that kind of thinking doesn’t lead to consistent gains in the market.

Why? Because, as Lynn Carpenter, a member of the Oxford Club Investment Advisory Panel, points out, it is a lot tougher (and more unlikely) for a $5 stock to go up $2 than it is for a $50 stock to do so. At the same time, the higher-priced stock is much more likely to keep any ground it gains. That’s because more expensive shares tend to be for businesses that are older, larger, and more stable. Older, larger companies (and particularly older, larger, profitable companies) are far more stable than smaller, start-up companies.

It’s a fact of life, a fact of investing you cannot ignore. Investing in micro-caps (companies that have small capitalizations — usually, smaller startups) is more speculative than investing in, say, blue-chip stocks. Big-cap stocks are less likely to be whipsawed (see “Word to the Wise,” below). If they move higher, chances are there are fundamental reasons for it.

But even if you understand why it makes sense to buy quality, it can be difficult to convince yourself to pay full value — $50 or $75 or $90 or more — for shares of an excellent company instead of grabbing up some shares of a bargain-basement company at a small fraction of that price.

It’s human nature to try to find nuggets of gold in a pile of dirt. And if you want to be a successful investor, you need to confront that impulse inside you. Recognize that it is there and make friends with it.

Here’s how:

When you hear about a stock that is immensely undervalued, remind yourself that there may be — and probably will be — a very good reason for it. If you can’t resist the urge to investigate the stock, look for omissions in the story or little details that seem out of place. Investigate it with a skeptic’s point of view. When you discover a potential problem that can’t be completely explained away, step away from it.

If all the research checks out and you want to go ahead and invest in it, do so. But put a trailing stop-loss on it beforehand and stick to

it. The main point is this: Stop worrying about price when it comes to investing.

The cost of the individual share doesn’t matter. What means something is the value. Paying too much attention to the price will make you vulnerable to buying cheap stocks with little value and passing up investments in very good stocks with share prices that happen to be high.

This happened to Lynn Carpenter, she recently explained, when she passed up a chance to purchase shares of Bob Evans Restaurants because they were too high for her taste. That decision cost her roughly 4,000% in “lost” profits over the next couple of years. The same thing happened to me when I opted to buy 1,000 shares of a $2 stock instead of 100 shares of a $20 issue in the same industry. The $2 shares tanked. The $20 ones gained 50% over a year.

Some investment advice is worth repeating: Look for value, not price, when shopping for stocks. And remember to practice self-discipline. Look for bargains, but resist the temptation to seek cheap prices.