Evening the Odds in Low-Priced Stock Roulette

When the government on Friday chose a team including International Technology Corp. to clean up the notorious Hanford, Wash., nuclear waste site, in six hours ITC’s shareholders made three times more than the average blue chip issue made all last year.

The Torrance-based company’s stock, which had languished for months around $5 a share on the New York Stock Exchange, leaped $1.125 Friday to close at $7.25--an 18% gain for the day, even though it isn’t yet exactly clear what the Hanford contract will mean for ITC’s earnings.

In a market that has become obsessed with the promise of smaller companies, ITC’s out-of-the-blue performance is just one example of what stokes the speculative fires. The higher the market overall goes, the greater investors’ desperation to latch onto the next hot small stocks.

And for many institutional and individual investors alike, “small stock” increasingly means low-priced stock--typically those under $15 a share, of which there are literally thousands spread across the NYSE, American Stock Exchange and NASDAQ markets.

In a maturing bull market, the allure of low-priced issues is the potential for fast moves and huge percentage gains, all for little money down. When you see a stock jump 18% in a day, after all, the game begins to look simple.

Yet it’s exactly when the stock market appears easily mastered that it can be most dangerous. While the small-company stock rally of the last two years may indeed go on for another few years, as many experts believe, picking winners is likely to become more difficult rather than less.

Even last year, it was easy for some pros to be humbled in the low-priced stock arena.

Randall R. Roeing, managing editor of the Low Priced Stock Survey, a Hammond, Ind.-based investment newsletter, produced a 75% return in 1991 for subscribers who bought his 10 favorite stocks at the start of that year.

But Roeing’s 1992 portfolio was a loser, falling 12% overall, even though the majority of small stocks gained during the year.

“It’s a minefield,” Roeing warns of the low-priced stock market, which he has studied closely for the last five years as head of the 7,000-subscriber letter. “There are so many companies whose stories today may sound great, but tomorrow they fall apart.”

Still, the rewards of picking correctly from the multitude of largely ignored small firms could be tremendous in a recovering economy. The question becomes, how does the small investor improve his or her odds of finding good companies and avoiding dogs?

Here, some tips from veteran low-priced stock investors:

* Start at the beginning. If you’re serious about finding low-priced gems, vow to buy only companies that you get to know--not hot tips.

You can latch onto small-company names in any number of ways: friends, business associates, the daily newspaper stock market summary, investment newsletters, or trade journals for specific industries (a favorite source of pros).

Your next move should be to call the company for its annual report, “10-K” file (a supplement to the annual report), and latest quarterly report, all of which will spell out the firm’s past performance.

The basic question you should ask is simply: Does the company have a product or service that people want in increasing numbers? If that isn’t apparent, you could be wasting your time.

“There are a lot of small companies that serve a niche, but soon completely saturate that niche and have nowhere to go from there,” says Joel Tillinghast, manager of the Fidelity Low-Priced Stock mutual fund in Boston.

* Learn the financials. Look at the company’s trend in sales and earnings. Both should be rising, or you should have strong reason to believe they will rise in the near future. Otherwise, there may be little to make the stock move.

There is no single earnings growth rate by which to measure a company. But as a general rule for the ‘90s, Tillinghast says, “If a company has a long-term growth rate of less than 10% (a year), I tend not to be interested.”

Another decision you must make is what’s a fair price to pay for the stock relative to earnings per share (the “P-E,” or price-to-earnings ratio). Big stocks normally sell for between 10 and 30 times the previous year’s earnings. Faster and/or predictable growth normally warrants a higher P-E.

But with many small stocks, the rapidly changing nature of their businesses--and their often erratic earnings records--make the P-E decision difficult. Especially if a small company’s earnings have shown no discernible pattern in recent quarters, you should be wary of paying a 20-plus P-E unless you’re confident that business is changing for the better.

How can you know that? The company may say so in its latest quarterly report--or the stock may begin to tell you. Which brings up the next bit of advice:

* Pick a stock that’s already moving. Whoever said “timing is everything” knew small stocks. The best time to buy many issues is when a handful of other investors have begun to zero in. “You want a stock that’s exhibiting some positive level of buying pressure,” newsletter-editor Roeing says.

Think of it this way: If no one else knows about the stock but you, it could be dead money forever. Or as Jim Collins, a small-stock veteran at Insight Capital Research in Moraga, Calif., puts it, “If you don’t have another buyer upstream, you’re basically a venture capitalist” rather than a shareholder.

Of course, small stocks can move up quickly on mere speculation, then fall back just as quickly. For that reason, it’s important that you know your stock’s trading pattern: where the price has been in recent years, whether it routinely bounces in a particular range, and how many shares typically trade daily (if you see volume surge, that may indicate new buyers). You’re looking for signs that the pattern is breaking on the upside.

Collins says his experience is that stocks in the $4 to $6 range often are stuck there because the companies have performed miserably. So he looks for stocks that have moved decisively above that range, suggesting a meaningful change in outlook. “We will often take notice of a stock around $8 or $9,” he says.

* Understand ALL the risks. Small businesses fail all the time, or just languish. That, of course, is your No. 1 risk with a small stock.

But investing in these issues entails other risks that don’t afflict bigger stocks. One is basic volatility: By definition, small companies have relatively few shares outstanding. So these stocks can leap or plunge on very little trading.

If you couldn’t handle your stock falling 50% in a matter of days--for no apparent reason--this market isn’t for you.

Mark Fried, who writes a newsletter called the R.H.M. Survey of Stocks Under $5, based in Glen Cove, N.Y., generally advises his clients to avoid any stock that trades less than 10,000 shares a week. Otherwise, the volatility can be hellish, he says.

At the very least, make sure you decide before buying whether a stock is a long-term investment or a short-term trade. And either way, Roeing advises setting a mental “stop-loss”--the maximum price drop you’re willing to accept before bailing out.

Also understand that you’re at the mercy of the brokerages that make markets in these issues. They can determine the price at any moment. So before you buy a small NASDAQ issue, be sure you also know what you could sell it for (i.e., know the difference between the “bid” and “asked” prices).

For example, if the bid is $6 and the asked is $6.50, you might have to pay the full $6.50--but to turn around and sell, you might get just $6. So the stock must rise at least 50 cents (8.3% in this case) just for you to break even.

If a stock’s bid-asked spread is more than 10%, Tillinghast says, you may want to reconsider buying.

* Finally, be skeptical. The majority of small companies are honest enterprises. But every year, investors get fleeced buying stocks of businesses that either are outright phonies or have been extremely overhyped by management or by brokers.

If a small company seems to be working extraordinarily hard to promote its stock these days--instead of running the business-- caveat emptor.

One Picker’s Low-Priced Favorites Here are nine stocks chosen by the Low Priced Stock Survey newsletter for hefty gains in 1993. The “EPS” figures show latest 12-months’ earnings per share. The “P-E” is current stock price divided by the earnings figure.

Stock/location 52-week Fri. 12-mo. (business) high/low price EPS Ag Services of Amer./Cedar Falls, Iowa (farm services/Midwest) $16 1/4-$8 5/8 $15 1/2 $0.98 Aspect Telecommun./San Jose (call processing) 15 3/4-6 7/8 15 1/4 0.32 GNI Group/Deer Park, Tex. (hazardous waste) 8 1/2-3 3/8 8 1/8 0.32 Interleaf/Waltham, Mass. (documentation sys.) 15-7 1/2 12 7/8 0.51 Kaman Corp./Bloomfield, Conn. (aerospace) 10 3/4-7 7/8 10 1/8 0.94 Kinetic Concepts/San Antonio (med. equip. rentals) 12 1/8-7 1/2 10 1/4 0.60 Medar Inc./Farmington Hills, Mich. (factory automation) 8 1/8-4 1/2 6 3/4 0.26 Mycogen Corp./San Diego (insecticides) 19 1/4-11 14 -0.36 REN Corp.-USA/Nashville, Tenn. (kidney dialysis) 15 1/4-7 1/2 13 5/8 0.35

Stock/location (business) P-E Ag Services of Amer./Cedar Falls, Iowa (farm services/Midwest) 16 Aspect Telecommun./San Jose (call processing) 48 GNI Group/Deer Park, Tex. (hazardous waste) 25 Interleaf/Waltham, Mass. (documentation sys.) 25 Kaman Corp./Bloomfield, Conn. (aerospace) 11 Kinetic Concepts/San Antonio (med. equip. rentals) 17 Medar Inc./Farmington Hills, Mich. (factory automation) 26 Mycogen Corp./San Diego (insecticides) NA REN Corp.-USA/Nashville, Tenn. (kidney dialysis) 39

All stocks trade on NASDAQ. Source: Low Priced Stock Survey; Standard & Poor’s (EPS figures)