Look before leaping into small stocks

10/29/99- Updated 02:09 PM ET


Look before leaping into small stocks

By John Waggoner, USA TODAY

Your neighbors are all buying stocks. So are your co-workers. Heck, the kids down the street are investing in Lemonadestand.com. You? You're sensible and have most of your money in mutual funds. But you have a little money put aside, and you want to try picking some stocks, too.

The operative words here are "a little" money. You want to spend maybe $2,500, preferably less. If you're buying in multiples of 100 shares - which can save you money on commissions - you're talking about stocks that cost less than $25 a share.

Evaluating such inexpensive stocks isn't as easy as evaluating a large stock like Intel. But it's not that much harder - and it can be rewarding.

Low for a reason

Most investors dream of buying a stock for $1 that turns into a 10-bagger - slang for a stock that gains 1,000%. But don't go that low - stocks priced below $5 a share are considered "penny stocks," and they can be dangerous. "When you get below $5 a share, the stinkers outnumber the 10-baggers," says Joel Tillinghast, manager of Fidelity Low-Priced Stock Fund.

Even stocks that sell from $5 to $20 need to be looked at closely. A $5 stock isn't low-priced by accident, says Robert Kern, manager of Fremont U.S. Micro-cap Fund. "It's that price for a reason."

And that reason is rarely a good one. In the best case, the company missed its earnings estimates for a quarter or two or is in an industry that Wall Street currently shuns. In the worst case, the company is shuffling off to oblivion. "You want to make sure you don't have complete wipe-out risk," Fidelity's Tillinghast says.

Check the numbers

So look for a strong balance sheet. Get the company's annual report and its most recent quarterly reports, either through a stockbroker or find them at the Securities and Exchange Commission's Web site, www.sec.gov.

Your first question: If sales take a serious downturn, does this company have enough money to survive the next 12 months? To get the answer, go to the balance sheet and find:

Current liabilities. This is the company's debt due within 12 months.

Current assets. This is the company's accounts receivable, cash, marketable securities and inventory - items that could be used to pay off current liabilities in a pinch.

Dividing current assets by current liabilities gives you a company's current ratio. You want this to be higher than 1, and preferably much higher. For a more conservative number, called the quick ratio, subtract inventory from current assets. Inventory can be tough to sell in a downturn.

You also should get an idea of the company's total debt vs. its total assets. In general, the less debt the better. How much is too much? It depends on the industry, Tillinghast says.

"Financial companies can support debt levels that would be terrifying to industrial companies."

Next question: Does this company actually make money? For that, look at earnings per share. Tillinghast likes to look for annual earnings-per-share growth of 10% or better. "If it's not 10% or more, I'll look for something better," he says.

And these are just starting points. You should be thoroughly familiar with the company and its fundamentals before you invest.

Different styles

Clearly, it's not easy to find a $10 stock that has no debt and 10% annual earnings growth. In most cases, that's because the company has stumbled recently. You have to figure out why the company's price might rise.

Different managers use different techniques. John Rogers, manager of the Ariel Fund, looks for stocks that are simply out of favor and should rebound. For example, HCC Insurance earned $1.57 a share the past 12 months. Like most property/casualty companies, it got clobbered this fall during hurricane season.

Analysts expect the company to earn $1.20 a share this year, which is short of expectations. But the stock's price is down more than 55% from its July 1999 high, while earnings are expected to be down only 24%. So Rogers figures it's been punished enough.

Erin Piner, manager of PBHG Limited Fund, looks for stocks with strong growth in earnings or sales. Her favorite low-priced stock, Hall Kinion & Associates, supplies staffing for Internet sites. Earnings have risen 58%, from 12 cents a share to 19 cents, and revenue is rising, too. "It's a low-priced way to play the build-out of the Internet," she says.

Most low-priced stocks are small-company stocks, and small-company stocks have been mostly ignored for years. So many of them are historically cheap. "I've never seen anything like it in the past 17 years," Rogers says.

More time and effort

Cheap or not, investing in individual stocks takes more time and effort than investing in mutual funds. Small-company stocks are often traded infrequently, which means you may have trouble selling for the last price you've seen quoted. You're also taking on more risk: There's always the chance a stock price can go to zero.

The stock picks in the chart are by some of the best small-stock fund managers in the business. But these are just starting points, and you need to investigate the stocks carefully. Otherwise, your tuition to Stockpicking University could be costly indeed. If this all seems like too much work, consider investing in a good small-cap stock fund instead.

Fishing for low-priced stocks

Finding small stocks can be tricky. Here, five pros offer some of their favorites. P-E, or price-to-earnings ratio, is a stock's price divides by its earnings per share. Higher P-Es generally show investors are willing to spend more, in the expectation of higher rewards.

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