December 17, 2023
Hilary Kramer is the author of The Little Book of Big Profits from Small Stocks (2012, Wiley). Kramer is a highly successful investor who has made most of her money by investing in single-digit priced stocks. She reveals her methods in this book.
Important Note: I am a value investor. I am looking to buy stocks at 50% or less of intrinsic value. Kramer’s approach is similar in many ways, but she is not a value investor per se. Kramer is still trying to buy stocks for less than they are worth, either relative to future earnings or relative to book value.
Kramer writes:
So why aren’t more Main Street investors looking to low-priced stocks? Well, one of the biggest beliefs on Wall Street is that stocks under $10 are too dangerous for most investors. Many institutional investors, such as mutual funds and pensions, are actually prohibited from owning stocks that trade in the single digits. Stock that have fallen below that magic $10 mark often lose the attention of the research departments, so no analysts follow them and they tend to be ignored. Wall Street often treats the single-digit priced stock sector as a graveyard, best passed as quickly as possible while whistling on the way to other endeavors.
Kramer has identified three categories of low-priced stocks:
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- Fall angels: These are large company stocks that have stumbled and fallen out of favor for various reasons. Some are cyclical stocks, while some were companies where management made mistakes and earnings fell short of Wall Street expectations.
- Undiscovered growth companies: Many of these happen to be overlooked because they are in unattractive industries.
- Bargain bin stocks: These are stocks trading below book value.
Kramer notes that it’s essential to read the company’s financial statements and investor presentations. There’s no easy way to high stock market profits.
Here’s an outline:
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- The Classic Under $10 Stock
- The Price Is Not Just Right, It’s Critical
- Oh, How the Mighty Have Fallen
- Growing Out of Sight
- Shopping the Bargain Bin
- Getting the World Healthy and Wealthy
- Around the World Under $10
- Forget Everything You Thought You Knew
- Looking for the Right Stuff
- Well Bought is Half Sold
- Beware the Wolves of Wall Street
- Low Prices and High Profits
THE CLASSIC UNDER $10 STOCK
Kramer mentions Darling International (DAR) as the classic $10 stock. The company collects used cooking oil and grease from restaurants all over the United States. Another division stops at slaughterhouses and butcher shops to collect hides, bone, and other animal by-products. They turn all this unusable stuff into useable products.
Kramer noticed Darling stock when it fell from $16 to $4. She found that Darling’s competitors were small, locally-owned companies that had a hard time competing with Darling’s economies of scale. At the time, the company had 39 facilities around the United States and 970 trucks and tractor-trailers collecting raw materials from 115,000 locations. Most of Darling’s customers were on long-term contracts.
Darling was growing rapidly both organically and by acquisition of smaller competitors. Revenues had increased from $323 million in 2003 to $645 million in 2007. Profits had almost doubled from $.29 a share to $.59 a share. The company had also paid down it’s long-term debt. Kramer:
Darling may be in a stinky business, but it is one profitable company. In spite of this, by the end of 2008 the stock was solidly in the single digits, trading at $5 and change. Recently, the company had moved into alternative energy where the collected grease could be used to create biofuel.
Darling stock hit $4, which is where Kramer bought. A little less than three years later, the stock exceeded $16. Kramer’s investment had produced a 300 percent gain. Kramer writes:
In this book, my goal is to help you find your Darlings. After two decades of investing, I can tell you that low-priced stocks are a great way to build, or rebuild, your wealth. Many of my biggest winning stocks over the years started out as single-digit priced stocks. They were stocks that were way off Wall Street’s radar screens for a variety of reasons, but once the Street and large institutional investors discovered them, they often soared in price.
Kramer says these breakout stocks share three characteristics:
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- Low-priced (mainly under $10).
- Undervalued.
- Have specific catalysts in the near future that put them on the threshold of breaking out to much higher prices.
That said, some stocks under $10 are cheap because they deserve to be. So it’s essential to have a good investment process, including reading the company’s financial statements and presentations. Kramer adds that she wish she hadn’t sold Darling, as the stock was soon in the mid-20s.
Kramer points out that there will always be recessions and economic slowdowns periodically. It is wise to build a list of obsessive lifestyle stocks, because usually these stocks sell off just like other stocks during a recession but the businesses in question tend not to decline nearly as much.
THE PRICE IS NOT JUST RIGHT, IT’S CRITICAL
The major brokerage houses have gone to great lengths to discourage trading in low-priced stocks. To be sure, there are many low-priced stocks belonging to bad businesses, bankrupt companies, and overhyped enterprises. But there are many solid companies that just happen to have hit challenges, causing their stocks to drop.
Kramer gives another example of a stock that hit single digits where the business itself was solid: Dendreon (DNDN).
Dendreon was developing a new drug manufactured from the patient’s own immune cells. This new drug represented a potentially groundbreaking step in the fight against prostate cancer. FDA approval looked imminent.
However, in May of 2007, the FDA decided they needed more trials and more information before they could approve the drug for widespread usage. The stock began dropping and by May of 2009, Dendreon stock hit $2.60. The market cap of the company had gone from $3 billion to $400 million.
Kramer did her homework and found that Dendreon’s new drug was likely to be approved after the new trials. It took some time for Kramer to buy a full position, but she ended up getting one at an average price of $5 per share.
In May 2009, the FDA approved Dendreon’s new drug. In less than two weeks, the stock was back over $20 and worth $3 billion again. The stock kept going up from there because it was clear the new drug would be a commercial success. A year later, Kramer sold for more than $50, a 900 percent profit—a ten-bagger. Kramer:
I am not going to tell you that every low-priced stock you buy in your lifetime will breakout and become a ten-bagger. Most investors only have a few of those in a lifetime. I am going to tell you that we can make Wall Street’s aversion to low-priced stocks work for you more often than not and produce consistent and exciting profits. Any ten-baggers you run across long the way will just be icing on the cake!
OH, HOW THE MIGHTY HAVE FALLEN
Kramer writes:
These are companies that were once considered blue chip or growth darlings that have fallen monstrously out of favor with Wall Street and investors. These are stocks that were once widely owned and if not loved, at least admired and respected. Something went drastically wrong for these companies and the share price plummeted into single digits. In most cases investors sold too late and much money was lost along the way, often creating a cloud of ill will and outright distrust for these companies in many cases…
Often in the stock market, though, aversion can signal opportunity.
Kramer explains:
When it comes to identifying true fallen angels, there are two key questions you need to ask. The first question is what went wrong? Did management overdiversify the basic business and expand into areas where they had no expertise or advantage? Did the company borrow too much money and is now having a hard time generating sufficient cash flow to service their debt load? Has a competitor surpassed them in the marketplace? Has there been a change in consumers’ buying habits and preferences that have left the company behind? Have there been accounting irregularities or regulatory issues that the company must put behind it in a satisfactory manner before the company can return to profitability? Are there customer or supplier lawsuits weighing on the company and its stock price? The list of problems, mistakes, and management stumbles that make a once great company into a fallen angel are legion. Before you even consider investing in a fallen angel stock you need to know exactly what went wrong and who is responsible for the problems.
The next question then becomes can it be fixed? Can the company shed itself of unprofitable divisions or subsidiaries that take away from the core business? Can management regain focus and catch back up to its competitors? Can the company generate sufficient cash flow to pay down its debt or can the balance sheet be restructured in a fashion that allows a return to profitability? Can regulatory issues be solved without permanent harm to the company? Can they maintain a reasonable relationship with key suppliers and customers until the current crisis has passed? Are the accounting and regulatory issues mistakes or are they fraudulent or criminal activity? Can their products and services regain acceptance from consumers? Once we figure out what has gone wrong, we need to figure out if the problems can be fixed. If so, we have a candidate for a fallen angel stock, and in my experience the companies that do achieve a turnaround can then see their stock price double or even triple before too much time passes.
Kramer is quick to note that many of these stocks are not good investments for a variety of reasons. So the investor has to carefully examine many such companies in order to identify one or a tiny handful of fallen angels.
Kramer gives the example of Ford Motor Company (F). For a long time, Ford was the bluest of blue chips. The company was incorporated in 1903 and is credited with inventing the production line method of assembling vehicles. In World War II, Ford creating a great number of vehicles to meet military demand.
Froom 2005 to 2010 however, the company stumbled. Not only had they acquired many other car companies and divisions that were not profitable, but they had rising healthcare costs combined with slowing sales and declining margins. Management then made a bet in 2006 that they might need cash. So they raised $23.6 billion in debt. The CEO said this would cushion the company if there were a recession. Kramer:
In 2008 the bottom came out from under the U.S. car market. The automakers were heavily exposed to the consumer lending market and as the credit crisis deepened default rates climbed and profits evaporated. In 2008 For had the worst year in its history, losing over $414 billion as the recession deepened. Auto industry executives ended up going hat in hand to Capitol Hill to plead for a federal bailout.
Here is where Ford’s gamble at the end of 2006 paid off. Both Chrysler and General Motors (GM) ended up having to file bankruptcy and accept government bailouts and funding. Ford had enough cash on hand from the cash-out refinancing that they did not have to go to those lengths to survive. Because they had cash on hand they could run their day-to-day operations without government assistance. They engineered an equity-for-debt sawp that reduced debt loads by more than $10 billion. Management worked out a deal with the UAW to accept stock in lieu of cash for pension and healthcare expenses. Ford’s stock fell under $2 in 2009 as things looked bleak for the entire industry, and it began to divest some of its noncore lines like Jaguar, Land Rover, and Volvo.
This was where Kramer got interested in Ford’s stock. Ford had lowered its debt and also Kramer found, after doing some research, that Ford’s F150 line of trucks was still dominant and the company had a loyal customer base. Two years later, Ford stock (F) had gone from $2 to $18.
Kramer next describes her greatest fallen angel investment ever, one where the stock increased dramatically over the 8+ years that Kramer held it: Priceline.com (PCLN). Many internet stocks had crashed after the bubble in 1999-2000. This included Priceline, which had hit $1 per share.
The company had made some misteps by trying to expand beyond travel services using a name-your-own-price model to sell gasoline, groceries, long distance telephone plans, and a host of other items. They also tried to compete with eBay (EBAY) in the online auction business. They even tried a name-your-own-price home mortgage program. Nearly all these ventures failed.
The stock had fallen from $165 to $1. But Kramer discovered that the company still had plenty of cash. And Priceline was exiting all of their noncore operations and schemes and returning to their basic travel business. Friends told Kramer they were still using the service and were still very satisfied. Kramer bought the stock in February 2003.
The company did a one for six reverse stock split. This made Kramer’s cost basis, adjusted for the reverse split, $7.63 per share. By 2011, the stock had hit $543 and Kramer was continuing to hold it. Kramer:
I have made over 70 times my money by finding this fallen angel and asking two crucial questions: What went wrong? and Can it be fixed?
What went wrong was obvious. The stock got caught up in the collapse of the Internet boom and management tried to enter businesses where they had no competitive advantage. And once they returned to their original core focus, I felt it could be fixed and that it was only a matter of time before business and the stock price began to grow again.
What’s the best way to find fallen angel candidates? Kramer offers several methods. Read the news, as the stocks of one-time leaders that have fallen are usually paid attention in the media. Look at 52-week low lists. Check all the stocks in the S&P 500 to see which ones are single-digit stocks. Finally, one of the best tools is to use a web-based stock screener.
After you have a list of candidates, you have to go to work reading the financial statements and company presentations. You have to ask the two questions: What went wrong? and Can it be fixed?
GROWING OUT OF SIGHT
You can make a lot of money if you own a growth stock, but the key is to buy at a low price. Kramer explains that many growth stocks are already very popular, which means their stock prices are already quite high. Kramer writes:
We are more interested in the type of stocks that legendary Peter Lynch described in his classic book One Up On Wall Street. Mr. Lynch described the perfect stock as one that was in a boring niche business. Preferably the company would be a business that was dull or downright disagreeable. He jokingly said that he would also like it if there were rumors of toxic waste or Mafia involvement! This type of stock would be way off the Wall Street radar screen, and few institutions would own it and analysts would not cover it or write reports for the sales force to pump the stock.
Kramer reminds the reader that she had already described just such a stock in the first chapter: Darling International. Rendering and grease collection is a dull messy business, but a necessary one. Kramer jokes that she has never been to a party and heard someone talking about the wonderful hide rendering company that was in their portfolio. Kramer:
This is exactly what made Darling such an outstanding investment opportunity. No one was paying any attention to the company as they grew into the largest company in the business and grew earnings rapidly. Darling was not only a classic under $10 breakout stock, it was also an undiscovered growth stock.
Of course, not all growth stocks that are still cheap are unknown. Sometimes investors simply give up on a company, which makes the stock low-priced.
Kramer suggests a class of companies she calls “obsessive product companies.”
These companies make products that people simply do not want to live without regardless of what is going on in the economy or the world. There are some hobbies or products that become lifestyles. Many of these are not recognized on Wall Street for the simple reason that they do not share the same interests or recognize that in many cases the company in question makes a product that is not going to go away regardless of the economy. If business does slow down a bit, it is simply going to create pent-up demand. Purchases may be delayed but they will not be denied!
Krames gives the example of Cabela’s (CAB), the outdoor superstore company. In late 2008, like other retailers, Cabela’s saw slowing sales and the stock fell to $5. Kramer explains what Wall Street missed: Cabela’s sells hunting and fishing products, and the buyers of these products are very serious about their chosen hobby. Also, while Cabela’s had over $300 million in debt, the company had close to $400 million in cash. Moreover, their credit card operation never really experienced big losses, again because their customers were very serious about their hobby and didn’t want to let their Cabela’s account become delinquent.
Furthermore, the company was asset rich. It owned 24 of their 29 locations, and the book value of the stock was over $12.
In 2008, Kramer began buying the stock under $5. By the end of 2009, Cabela’s had over $500 million in cash and they had reduced their debt. Kramer sold at $14.92, for a return of almost 200 percent in less than a year.
Kramer notes that there will always be recessions and slowdowns periodically. It is wise to build a list of obsessive lifestyle stocks. When recession hits, these stocks tend to decline just like other stocks even though the obsessive lifestyle businesses tend not to decline nearly as much as other businesses.
Furthermore, Kramer suggests looking for companies that can experience earnings growth without necessarily being exciting. She gives the example of Dole Foods (DOLE). The company was founded in 1891. In 2003, businessman David Murdoch bought the company from Castle and Cook. The company expanded into other lines of fruits and vegetables. In 2009, the company went public at $12.50 a share.
Nobody paid any attention. Kramer:
Dole had grown into the largest producer and distributor of fruits and vegetables in the world but to investors these were not exciting products. The stock price languished and early in 2010 it fell below the $10 mark where I began to take notice of the company.
Kramer believed that the demand for healthy foods was only going to grow in the years ahead. This was true not only in the United States, but also in many emerging markets globally. The stock soon increased 50 percent. Kramer writes:
The mantra of most growth stock investors is bigger, better, faster. They are looking for the newest fads and the most exciting products. The truth is that the best growth stories are often found in our cupboards and refrigerators. The regular seemingly boring products we use every day can create growth stories and when those companies see their stock price fall into the single digits, they become tremendous profit opportunities.
Kramer also recommends running a web-based stock screen. Search for companies that have been growing steadily for at least five years. Most of these stocks will already be high-priced, but occasionally you may find a low-priced one. Kramer:
…just finding one of these before Wall Street does can make a huge difference in your net worth over time.
Kramer:
To run this search, set the screener to look for stocks that have grown earnings and revenues by at least 15 percent a year for the past five years. We also want companies that do not owe a lot of money and have decent balance sheets. Legendary investor Benjamin Graham once set that threshold as owning twice what you owe, so I think that’s a reasonable threshold. Set the debt to equity ratio at a maximum of .3. This will give us a company with at least 70 percent equity and 30 percent debt as part of the total capital structure.
Of course, you also include on the screen the requirement that the stock price be below $10. Kramer:
Your list of stocks is going to be short and the companies will be small. In fact if you ran it right now for U.S. stocks the resulting list would be just 51 names out of all the stocks listed on major exchanges and markets here in the United States. The largest company on this list is going to be just $750 million in market capitalization and the smallest is just under $30 million in total market cap. There are some pretty interesting companies and it will be worth your time to search this list and dig a little deeper to find the real winners out of this list. You want to look for companies with products that have exposure to huge potential markets like alternative energy, smartphones, and other communication devices, social networking, or any other product or service that can see continued steady growth for years to come… Decent levels of insider ownership are also preferable in these small, steady growers. If the founders and managers of these little growth gems still own a good share of the company, say 10 percent or more, they have a vested interest in seeing the stock price go higher over time.
Kramer next mentions a screen for explosive growers. These are low-priced breakout stocks that have seen a surge of earnings and revenues in the past year. Kramer:
We usually find two types of companies on this list. One is a company that stumbled or is caught by the economic cycle and has had depressed earnings and sales. Now the cycle has swung back in their direction and they are set to surge. The other is a company that has a breakthrough with some product or service that suddenly takes the world by storm and is set to explode upward.
We want explosive growth here so we will initially set the bar high. Set your screener to look for companies with earnings growth of at least 100 percent annually. Often profit margins are also exploding so revenue growth is not as critical with this screen. Again, we do not want too much debt, but we can give these exploders a little more room, so set the debt to equity ratio ceiling at 50 percent.
Once again, a recession or a bear market can create many low-priced stocks among the explosive growers. Kramer says the investor will learn to love recessions and bear markets for this very reason.
SHOPPING THE BARGAIN BIN
This is the method of finding stocks that are trading below tangible book value. (Intangible assets are not included.) Kramer:
Bargain bin stocks sell below book value for many reasons. The company could be experiencing a slowdown in its business and Wall Street has abandoned the stock. The whole industry may be unloved, as was once the case with electric utility stocks back in the 1980s. Cost overruns on nuclear power plants and a hostile regulatory environment had all of these stocks selling for less than their book value. In the aftermath of the Savings and Loan crisis in the early 1990s, almost all small bank and thrift stocks sold well below the value of their assets. Sometimes it is just a stock that is too small for analysts to follow and the stock price has languished as the assets have grown. Our job is to figure out if those assets can be converted to either a higher stock price or be turned into cash via a takeover or restructuring in the near future.
Kramer gives the example of Tesoro (TSO), a major North American refiner of petroleum products. In 2008, its stock fell well below its book value. When the economy slows down, business is awful for refiners. However, the company had many tangible assets and we knew the recession would eventually end. Tesoro owned seven refineries and 879 retail gas stations. Tesoro also owned 900 miles of oil pipelines around the country. The most important point, writes Kramer, is that there are not many refineries in the United States. There hasn’t been a new refinery built in the United States since 1977. Therefore, these are irreplaceable assets. Kramer:
The assets already appeared pretty valuable to me. Although the business was terrible the asset pile was worth a lot of money. With the stock trading around $8 or so the tangible book value of Tesoro was about $23 a share. The assets were being discounted in the marketplace by more than 65 percent. That was just the discount from the accounting value of the assets. Because refineries are irreplaceable assets the discount was even greater when you considered the real value of Tesoro’s asset collection.
Kramer bought Tesoro around $8. Once the economy recovered, so did Tesoro’s profits and the stock soon tripled.
As far as screening for companies trading below tangible book, Kramer also recommends that the companies be profitable so that they are not burning through their assets. Kramer then recommends including on the screen that the debt to equity be a maximum of .30. And of course, the screen includes stocks that are below $10. Kramer concludes the chapter:
When we look over the list of stocks priced cheap compared to their assets, we want to consider what the actual assets are. The key question is: Can they be turned into profits at some point? If the assets are cash or commodity inventories, the answer is probably yes. They can be sold, returned to shareholders, or perhaps a competitor or private equity investor will recognize the value and buy the company at a premium. Are the assets real estate, such as commercial properties, hotels, or apartments? If so they can also probably be sold at a profit at a point in the future.
GETTING THE WORLD HEALTHY AND WEALTHY
The opportunities in low-priced stocks, whether fallen angels, undiscovered growth gems, or bargain stocks, occur in a variety of sectors. That said, some sectors may be particularly interesting, depending upon the investor and his or her expertise. Kramer mentions the biotech and pharmaceutical sector:
This particular sector is absolutely overflowing with low-priced investment opportunities—a trend I expect to continue in the near future.
There are a few key reasons for the sector’s hot hand. The most obvious reason is the advancements in technology. It seems like there is a new breakthrough drug, medical treatment, or device almost every week. We have seen advances not just in biotechnology, but in robotic surgery, titanium hips, cancer protocols, and life extension programs. Increasingly we are seeing the breakthroughs come from smaller companies wth smaller stock prices.
Kramer adds that there is a real need for these products. For example, in 2010, nearly 1.6 million Americans were diagnosed with cancer, and 570,000 died from the disease, according to the American Cancer Society. Furthermore, according to the University of Texas M.D. Anderson Cancer Center, the number of new cancer cases diagnosed annually in the United States is expected to increase by 45 percent to 2.3 million in 2030. There are also increasingly more cancer cases globally.
In the United States, according to the National Cancer Institute, part of the National Institute of Health (NIH), total expenditures on cancer treatment will grow at least 27 percent from 2010 to 2020, advancing from $127.6 billion to $158 billion. Kramer notes that the good news is that these treatment dollars are being funneled into innovative companies fighting this disease.
Here’s where the importance of smaller, lower-priced companies in this sector comes into play. The giant drug companies are looking to partner with these smaller companies to develop new products as an addition to their own research and development efforts.
Sometimes big pharmaceuticals, if they don’t partner with a smaller company, will acquire the company instead.
Kramer mentions that she bought Ariad Pharmaceuticals at $8 a share in 2011. Ariad is an emerging biopharmaceutical company that at the time had three potentially game-changing cancer treatments. Kramer explains that for one of these treatments, Merck partnered with Ariad. Kramer comments:
The partnership approach to developing drugs is going to be the model of groundbreaking research in the future. By setting up news searches and tracking the news of the largest pharmaceutical companies, you can keep on top of the exciting smaller companies that are working on potential blockbuster drugs.
Successful partnerships with larger drug companies have turned some single-digit stocks into huge winners. Regeneron (RGEN) has seen its stock price go from under $6 a share to well over $60 in just over five years as its partnership with pharmaceutical giant Sanofi-aventis has allowed it to develop promising cancer and autoimmune system drugs. Incyte’s partnership with Novartis helped drive the strock price from $2 to over $20 in three years.
Smaller biotechnology companies can push the curve in new research in ways that larger more established companies simply cannot. Rather than invest in unproven drugs and technologies, the larger companies prefer to provide cash and assistance to the up-and-coming companies. In return they can access potential breakthrough drugs with less overhead. It is a win for the company, for investors in the smaller company, and often for patients. As researchers and biotech companies continue to search for the answers for mankind’s medical issues these opportunities for low-priced breakout stocks will be increasingly available to attentive investors.
Kramer also mentions breakthroughs in medical devices and surgical techniques. This includes new cardiac stents being developed, new robotic surgical devices, new bone and joint replacement products, and many other devices and products to improve health and combat age-old problems.
Kramer points out that it takes some specialized effort to effectively search the universe of healthcare, drug, and biotechnology companies. Sometimes growth screens will produce ideas, but often more digging is required. Kramer concludes:
You can find news on such developments at www.fda.gov. The site has a wealth of information of new drugs being approved and which companies are developing them. It also tracks which drugs are in short supply and could lead to production ramp-up or higher margins for their manufacturers. The site also has information and reports that will help you understand the approval process for new drugs which will prove useful over the long run as you search for cheap stocks in the medical and drug fields.
This is an area where you probably need to learn to steal ideas as well… It took me many years to develop the expertise and contacts needed to continually uncover the potential big winners, particularly in biotech stocks. You can get ideas from top managers in the field by searching through the portfolios of top mutual fund managers specializing in the medical and biootech fields. They have to disclose their portfolio to the SEC and are widely available on various research and financial sites on the Internet.
One new drug or technology can take a company from obscurity to superstardom and the stock price will go higher than you could have ever though possible. Staying on top of which smaller single-digit stocks have promising research and strong partnerships with large drug companies can be a tremendous source of single-digit stock winners over your investing career.
AROUND THE WORLD UNDER $10
Emerging markets have evolved and become more like U.S. markets. There are the same cycles of fear and greed that create fallen angel stocks. Kramer:
Companies will be created that have exciting new products with the potential for strong long-term growth and yet stay under the radar screen for an extended period of time. We can find low-priced potential breakout stocks located all around the world in today’s dynamic, connected stock markets.
Kramer comments:
In a lot of ways emerging economies look a lot like the United States did back around the turn of the century. Back then people moved from the rural towns into the cities as jobs in new industries became available. Automobiles began to replace the horse and buggy. Radios and telephones became items that were desired by every household. Investing in companies that built infrastructure, like the steel and railroad companies, was hugely successful. So was putting your money into electric utilities and energy companies that served the growing demand for power. Early investors in companies that sprang up to serve these new consumers, like Sears, Roebuck and Company, also did very well.
Today we are seeing similar trends developing, as smartphones and portable commmunications and entertainment devices are adopted throughout the world and are in high demand in emerging economies like China, Brazil, and India. Further, the robust demographic growth in emerging economies is creating the need for bigger, better, and more efficient infrastructure to maintain such growth.
Kramer gives the example of Cemex (CX). When she was in Mexico in 2001, Kramer noticed the country was experiencing a building boom. She got curious about all the cement trucks and construction vehicles, not to mention cranes. CX not only sold cement in Mexico, but also in the United States, Europe, the Philippines, and the Middle East. Kramer bought the stock around $8 in early 2003, and over the next three years, the stock went over $30, allowing her so sell at around $29. Kramer continues:
Interestingly, the stock collapsed again in the global recession of 2008. As global building began to collapse as credit tightened and the economy slowed, the shares fell all the way back into the single digits. In fact, Cemex stock fell below $4. Once again, as the global economy began to dig itself out, the stock slowly reversed and reached a high of $14 a share a little more than a year later.
Building materials stocks like Cemex are going to get hit hard during a time of a global slowdown, but will be among the first and fastest to recover at the first sign of an improvement in economic conditions. Emerging markets may have frequent stumbles along the way to progress but once the trend towards a more industrialized consumer society begins, history tells us it rarely reverses itself. Following building supply- and infrastructure-related stocks and buying when they are low priced and unpopular can be a path to large long-term profits.
Moreover, as an emerging economy creates a new middle class, there will be demand for goods and services that make life more interesting.
FORGET EVERYTHING YOU THOUGHT YOU KNEW
First, the efficient market hypothesis, which says all available information is already reflected in all stocks and therefore it’s impossible to beat the market except by luck, is simply not true. Most of the examples Kramer has given illustrate this. Also, various value investors have beaten the market over time for nearly a century.
Second, a low P/E ratio is not typically how to find a low-priced breakout stock because often a low-priced breakout stock has very little earnings, which makes the P/E ratio very high.
My note here: My fund, the Boole Microcap Fund, uses five metrics for cheapness:
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- low price-to-earnings (low P/E)
- low price-to-cash flow (low P/CF)
- low price-to-sales (low P/S)
- low price-to-book (low P/B)
- low enterprise value-to-EBITDA (low EV/EBITDA)
In the terrific book, What Works on Wall Street (4th edition), James P. O’Shaughnessy demonstrates that using all five of these metrics of cheapness simultaneously has produced the highest returns historically.
My fund also uses other quantitative information like a high Piotroski F-Score, low debt, high insider ownership, insider buying, high ROE, and positive 6-month and 1-year momentum.
So while I do agree with Kramer’s explanation of fallen angels, undiscovered growth stocks, and bargain bin favorites, I don’t entirely agree on low P/E. It’s OK for the P/E to be high (or even negative!) as long as most of the other metrics of cheapness are low. However, I do estimate normalized sales, earnings, and cash flows, and if most of the metrics for cheapness are quite low relative to normalized estimates, then these can be particularly interesting stocks.
Moreover, if a company has been profitable for years, and then suddenly has its profits disappear for temporary reasons like a recession, that can be the makings of an excellent investment when the stock price has collapsed.
Kramer says a high P/E is OK if earnings have temporarily collapsed, but she does write the following:
As a rule we want our companies to be profitable. As we discussed, many of them stumbled and that’s why they are a low-priced stock in the first place. The fact that they are still profitable in the worst of times gives us an indication management knows what they are doing and can return to higher profitability levels in short order. If they are not profitable there needs to be some reason or catalyst that we can see that will restore the bottom line to black ink in a relatively short period of time.
Kramer continues by explaining that an improvement or deterioration in various metrics can be more important than the absolute level:
Let’s consider return on equity for a second. This is a widely used measure in financial research that evaluates how much a company is earning relative to the amount of equity invested in the company. It is a pretty good measure of how profitably management is using the money entrusted to it by shareholders. However just the number by itself is not enough to evaluate a stock for breakout potential.
Kramer gives the example of Toll Brothers (TOL). The company has a decent year in 2006 and had a return on equity (ROE) of 20 percent. That seems good, however year over year the ROE had declined from 53 percent to 20 percent. This was, for Kramer, a huge red flag. The trend continued and TOL had a small ROE in 2007 and negative ROE in 2008. This example illustrates why the direction of many metrics can be more important than the absolute level.
LOOKING FOR THE RIGHT STUFF
Kramer holds that the company should have a relatively strong balance sheet, and own at least as much as they owe. In other words, the debt to total capitalization should be below 0.50. If it’s higher than that, there is an increased risk of bankruptcy during a recession or business slowdown.
Kramer writes:
It is also very important to read the footnotes and fine print in a filing of a prospective stock. I want to see if the auditors signed off and issued an unqualified opinion of the company’s financials. If they issued a qualified opinion that’s a huge red flag that something may be wrong with the data I am using to evaluate the company. Has the company recently changed auditors? That can be a flag as well, and indicates the previous firm had some questions that company didn’t want to answer or did not like the conclusions the auditor drew out of the financial data. Is there a concern about the company’s ability to continue as a going concern? Are there a lot of complex off-balance-sheet arrangements? These could have a substantial negative influence on the company’s leverage and operating ratios that are not included in the basic balance sheet and income statement presentation.
Kramer highly recommends going to the investor relations part of a company’s website. She gives Wendy’s/Arby’s Group (WEN). (Keep in mind Kramer was writing this book in 2011. Today Wendy’s and Arby’s are separate entities.)
When I go to the investor relations section of their website I find links to all their SEC filings, historical information about their finances, and stock price. The last few years of press releases, including quarterly earnings reports, are readily available. The really interesting section to me is webcasts and presentations. Here I find links to recent presentations at various conferences and investor meetings, including videos and PowerPoint presentations.
…
I see from the presentation that the company is introducing a new line of burger products in the second half of 2011 that look pretty enticing. They have a strong balance sheet and are buying back stock. I see in the presentation that they have recently increased the dividend. Managing is continuing with their efforts to sell the Arby’s business and refocus on the core Wendy’s brand. The presentation contains information about international expansion plans, menu changes, as well as a discussion of finances. This is all valuable information and reinforced my conviction about owning the company.
Kramer adds that not all companies have in-depth investor presentations, but many do. Note: Many microcap companies—the focus of my fund, the Boole Microcap Fund—do not have these presentations, but some do.
Kramer continues:
The next thing I like to do is look at the stock price chart. I am not a chartist by any means, but the price chart can provide valuable information, especially in timing my purchase of a low-priced breakout stock. Is the stock moving higher on increased buying activity in the stock? This could be a sign that the larger investors, such as hedge funds, are starting to notice the company and I want to get in as soon as possible. Is the stock breaking out to new highs? Has it bounced off a level of support, such as a double price bottom that might indicate institutional buying is putting a bottom in the stock and the time to buy has been reached? I never make a decision because of the chart itself but if the stock has passed the research process, charts can provide valuable information about what other investors think of the company.
Kramer adds:
Another important piece of information I like to check when evaluating a stock is who is buying and selling the shares. Are insiders buying or selling the stock? If they are selling is it just one officer or director or several of them? One seller could be someone in need of cash for some personal reason but many sellers over a period of time is a huge red flag. If the folks running the company are selling, I am not so sure I should be buying the stock. I need to check my conclusion. Insiders may sell for several reasons, but they only buy for one: They like the potential of the company and think the stock is underpriced relative to the potential for gains in the future. Insider buying increases my conviction about a company that has passed all my other tests.
Kramer also recommends calling experts, which is easier if you happen to know some, but can still be done even if you don’t.
Moreover, Kramer mentions some great research resources, including Value Line, which not only has momentum-based rankings, but also has a decade’s worth of historical financial data plus analyst commentary. Standard and Poor’s also publishes valuable stock research. Furthermore, some of Morningstar’s equity research is available for free. Yahoo! finance has free information on companies.
Note: There are other resouces, too, including Seeking Alpha, for which you have to pay roughly $33 a month. And, for microocap investors, there is the Micro Cap Club (https://microcapclub.com/), which you can join for $500 a year (or for free if you write up an investment idea and it is accepted) and also Small Cap Discoveries (https://smallcapdiscoveries.com/), which costs $1,000 a year.
WELL BOUGHT IS HALF SOLD
First, every investor will make plenty of mistakes. Many top investors are only right 49% of the time or up to 60% of the time. How you deal with mistakes is important. I wrote last week about this: https://boolefund.com/the-art-of-execution/
Sometimes, if the stock falls, it makes sense to buy more. Other times, it’s best to sell. The most important question to ask yourself is: Knowing what I know now, would I buy the stock at its current price? If yes, then buying more after the decline is the right move. If no, then immediately selling is the right move. Remember the quote attributed to John Maynard Keynes:
When the facts change, I change my mind; what do you do?
Kramer writes:
You want to read any filings or news releases since you bought the stock. Has the company taken on more debt? Did they miss a key product launch date? Is the company spending its cash at an alarming rate? Are inventories growing as customers delay or cancel orders? Have regulatory or legal issues emerged that change the outlook for the company? Have the macroeconomic issues that face the company changed since you bought the stock? You are looking for material negative changes in the company or its outlook since you originally bought the stock. If there are any, then you want to sell the stock. The old adage that the first loss is the best one holds true. If the situation worsens, do not wait for a bounce or to get back to even—sell the stock and move on.
Kramer next handles the topic of when to sell winners. If the stock price has gone up, you want to review the situation. Are revenues and profits still growing or rebounding? Is the company paying down debt or otherwise fixing any balance sheet issues? Are the company’s products being well-received?
Kramer then adds:
On the technical side of things, is daily trading volume increasing or at least staying steady? This can be a sign that the big institutions that sold the stock when it was falling are now buying back in and this is going to push the stock price still higher. Is the stock making new 52-week highs? Are you seeing a steady pattern of higher highs and, more importantly, higher short-term lows in the stock? Stocks are always going to move in ebbs and flows. When you chart a low point of a pullback above the low point of the prior round of profit taking, this is a very bullish sign for the stock. Buyers are moving in and the stock is probably heading higher, so ride the wave and let your profits grow.
As long as things are improving you want to own the stock. I have stocks today like Priceline that I have simply never sold even though they have risen by hundreds of percent.
Kramer then writes:
As a stock move higher there are some indications that indicate it is time to part ways with the stock. If business starts to slow and is no longer improving it is time to sell. If revenues and earnings have been rising and then the company announces a down quarter, it is time to ring the register and take your profits. If you have a stock that has moved higher and the company announces a large debt or equity offering, you want to consider selling the shares…. The need to raise moeny is a sign that the company is not generating enough cash to meet its goal and it’s a reason to consider taking profits.
Sometimes it also makes sense to sell part of the position as the stock movies higher. This, too, is covered in last week’s blog post about The Art of Execution: https://boolefund.com/the-art-of-execution/
Kramer makes another important point: If it seems like now everyone loves the stock, whereas previously (when the stock price was low) they hated or ignored the stock—which is what created the opportunity for you to buy at a low price—then it’s time to consider selling. The question becomes: if everyone loves it, who is left to buy?
Finally, sometimes the stock you own will get acquired, in which case you have to sell but can usually do so at a higher price than you paid. It also makes sense, argues Kramer, to be aware of when larger companies may want to buy smaller competitors. Often such inorganic growth (via acquistions) is less expensive than organic growth (opening new locations, developing new products, etc.). As discussed earlier, this can frequently be the case for large drug companies: In order to expand their product lines, they will look to acquire smaller companies.
BEWARE THE WOLVES OF WALL STREET
Low-priced stocks are viewed as riskier than higher-priced stocks, but usually that’s not case. Kramer writes:
All things being equal, the answers to the risk versus reward equation are found in the financial statements, not the stock price. This is a classic case of broad-based statements, such as ‘all low-priced stocks are risky,’ just being wrong.
That said, as an investor you do have to be careful of “pump and dump” schemes, which historically have often happened with very low-priced stocks. Kramer:
Unscrupulous operators accumulate or create a large block of stock at a very low price. They then hype the stock as the next big thing to unsuspecting investors. They talk about getting in on the ground floor, revolutionary breakthroughs, and other buzzwords designed to get the blood pumping and the greed flowing. When investors get excited about this wonderful company, the operators simply dump their stock at much higher prices and walk away with investors’ hard-earned money.
Most of the time these companies have no real business or assets. They are just shell companies set up for the specific purpose of fleecing investors. Some of them may be little mining stocks or small tech companies that are badly underfunded and will be broke and bankrupt very shortly.
Kramer adds:
The SEC has done a great job of cleaning up the penny stock brokerage firms and they are not as prevalent as they once were. However there are still a few out there and as long as greed and dishonesty exist there always will be.
Krames then writes:
I do not want to imply that all Internet-based research on low-priced stocks or advisory services devoted to low-priced stocks are bad. I run such a service myself and I know several other reputable conscientious folks who do the same. The best defense against being taken advantage of in the stock market is to do the homework yourself and check the facts before you buy the story! You will quickly be able to see who is trying to make you money and who is trying to rip you off.
Furthermore, you must be aware that there are many low-priced stocks that deserve to be low-priced. Also, nearly every company that goes bankrupt sees its stock go to a low price before bankruptcy. That’s why it’s important, again, to do your homework. You have to be sure the company doesn’t have too much debt. Also, is the company making money or losing money? If the company is losing money, do they have a credible turnaround plan in place? Kramer:
If you see allegations of accounting or securities fraud in a company’s reports, it is best just to take a pass on that issue even if you think there is potential. Unless you are a very experienced forensic accountant or securities attorney, it becomes very difficult to decipher exactly how these cases will end. Lots of people thought companies like Enron and WorldCom would be able to survive after the initial fraud allegations were revealed. They were not and a lot of people lost a lot of money.
Kramer concludes the chapter:
The key to avoiding risks in the stock market, especially in low-priced stocks, is to use common sense. No one is going to send you an email to tell you all about a stock that is going to make you rich beyond your wildest dreams. As I have said earlier in this book, finding these gems takes work and effort on your part and no one is going to give you the keys to the kingdom with no effort or cost on your part. Keep in mind, if your Uncle Fred were really a great stock picker he would not borrow $100 every time you see him. Read the 10Q and 10K, go through the financials, and read management’s discussion of the business. Check the footnotes for warning signs and red flags.
Most of the time the alleged risks of low-priced stocks are just that—alleged. If you find a stock with the right financial and business characteristics the risks are actually nonexistent. It is the perception of greatly increased risks with low-priced stocks that is creating the opportunities for us to earn breakout profits.
LOW PRICES AND HIGH PROFITS
In this chapter, Kramer wraps up the book. She writes:
Hopefully I have given you the tools and information you need to begin investing in the exciting world of low-priced breakout stocks. Over my years in and around the financial markets I have found this to be the single best area for investors to earn explosive gains in stocks.
Kramer again:
By getting ahead of Wall Street in lower-priced stocks we benefit from the institutional pack-mentality that dominates many traditional investment managers. When they are selling and pushing stocks to low prices, we are buying. Then, when their excitement for these stocks return, we are selling to them. We are finding solid growth stocks before Wall Street notices and will see our stocks soar when they show up on the Street’s radar screen. There simply is no better way for individual investors to outperform the market in my opinion.
Kramer argues that it pays to be optimistic about the long term:
If you focus on the fear you miss opportunities. If you focused on all that was wrong with the auto industry in 2008, you would have totally missed the fact that Ford was in fine shape and stood to benefit fomr the problems of its competitors. If you gave up when Dendreon got the first delay from the FDA, you would have missed some spectacular gains by never investigating further to discover that it was just a delay and approval for their cancer drugs was probably forthcoming.
The same applies to the stock market itself. Markets are going to have declines. There will be recessions and bear markets throughout your career. The right way to look at these occasions is as inventory creation events, not catastrophes.
I would add that often microcap stocks have a low correlation with the broader market. Warren Buffett, arguably the greatest investor of all time, said in 1999 during the internet bubble:
If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.
Kramer writes:
There is another advantage to owning low-priced stocks when the market corrects. Many of these stocks are fallen angels or growth companies that stumbled briefly, driving the stock below $10. Wall Street and the big institutions already sold their shares and your stocks will not experience the type of selling pressure higher-priced issues are experiencing. When the large leveraged investors, like hedge funds, need to sell stocks they sell the higher priced more liquid issues to meet margin calls, not lower-priced smaller companies. So not only does the selling not hit your stocks as hard as the big names, they often push the big companies down to where they become inventory for you!
Kramer continues:
The best investors fit into the category that I like to call optimistic cynics. They are well aware that every bear market has ended and every economic recession has been followed by an economic recovery. They also know that the world is fully of entrepreneurs and innovators who will discover new solutions to old problems and the world gets better over time throughout history. They know that companies that are out of favor today are often tomorrow’s darlings. In the stock market, optimism pays off over time. It always has and always will.
The cynical part comes from not taking anyone’s word for anything. Trust but verify is the order of the day. Great investors do not act on tips, rumors, and sales pitches. By doing their research and homework they avoid many of the mistakes investors can make that will damage their net worth. They dig into the financial filings and company presentations to determine what is really going on with the company and the likelihood they can recover or continue to grow. When markets are soaring and everyone is piling into stocks, great investors ask the most critical question of all: Is it really different this time? When markets are collapsing they ask themselves if the world is really ending. The answers to those questions help to temper your enthusiasm at market tops and turn your fear into action at market bottoms.
Kramer advises reading as much as possible, which she says is “some of the best advice I can give you about successful investing.” Not just people who agree with your views of the world, the market, and stocks, but also people who disagree with your views. Sometimes you will find holes in your thought process and other times you will gain more confidence in your previous conclusions. Either way, it can make you a better investor.
Kramer reminds us that we have to pay close attention to the footnotes to search for any red flags or time bombs. Also, the company presentation, often available on their website, usually contains valuable information about new products, services, or markets, as well as management’s plans.
It’s also a good idea to see if insiders are buying. If they are, that’s always a bullish signal because it means the people running the company believe the stock is undervalued. On the other hand, if groups of insiders are selling, especially at a low price, that’s a huge red flag. Moreover, if excellent professional investors are buying or selling, it’s a good idea to pay attention to that.
Kramer ends with the following:
Investing in low-priced potential breakout stocks is work. However it can increase your net worth quicker than almost any other effort applied to investing I am aware of. One investment like Priceline can make it easier to put the kids through college or retire a few years earlier. An investment in an undiscovered growth gem like Darling can pay for a dream vacation or even a dream home. If you are willing to work at it, investing in single-digit stocks should add many digits to your account values over time.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: jb@boolefund.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.