An Investor’s Roadmap for Finding and Buying Low-Priced Stocks
‘Buy low, sell high’ is the time-honored proverb of investing. Investors who wind up ahead of the game have successfully bought low enough often enough, while investors who wind up out of the game have bought high and sold low once too often.
Since ‘buy low, sell high’ is the fundamental maxim of investing, there are, of course a plethora of ‘buy low, sell high’ schemes promoted by one self-serving party or another to lead investors to the promised land. With the so-called electronic highway, the ‘buy low, sell high’ pitches will probably crop up on computer screens with great regularity.
Many of the promises with which we are inundated tend to miss the boat. In order to effectively buy low and sell high, investors have to truly buy low. So, the appropriate question to ask is: “Do you really tend to buy low?”
Take the average stock price on the New York Stock Exchange. The average price of all stocks traded last year was $34.12, right about in line with the historical range where stocks trade of between $30 and $40.
Yet, while most buying and selling took place in stocks in the $30 range, that is not where the gains were to be found. While last year’s average price was higher than the prior year’s figure of $33.97, it was only higher by $0.15, or 4.4%. Another measurement, the NYSE composite, was up only 7.86%.
On the other hand, the average price of the 10 leading big board performers, showing an average gain of 207%, was 123/8. Six out of the 10 issues were under $10, with five under $5. The lower the price, the greater the gain.
Was 1993 a fluke?
If there was any aberration in 1993, it was that the price of the best performing stocks ended up on the high side. The year prior, 1992, the average price of the 10 top gainers was $5.35, with an average gain of 229%. The year before, 1991, the average price was $4.20, with an average gain of 532%. The facts demonstrate, year-in, year-out, that the best gains are achieved from low-priced stocks.
My research further shows that the best gains among the Dow Jones industrials are from the lower-priced components. The same holds true with the transportation average and the utilities average. The stocks fueling the rise in these averages tend to be the lower-priced stock components.
The January effect, the subject of my September 1993 AAII Journal column, is largely a low-priced stock effect. While after my article I saw a range of opinions surface regarding the usefulness of the January effect, the price-oriented January effect, as represented by S&P low-priced stock index, outlegged its larger brethren, the S&P 500, by more than 21/2 to one. The results in January 1994, like a half-century of statistics of past Januarys, attests to the low-priced stock nature of the January effect.
The lesson to be learned is that if you really want to improve your chances of superior investment results by buying low and selling high, you had better look for low-priced stocks.
Of course, as we really know, there is no such thing as a free lunch, especially on Wall Street, and there is certainly no free lunch in low-priced stocks. Low-priced stocks are risky, reflect a lack of “acceptable” fundamentals, they pose a high degree of uncertainty, and they are not widely followed by Wall Street analysts.
On the flip side, the degree of unpopularity, or lack of interest, or extent to which any one issue is depressed from previous levels, defines the superior profit potential available in these issues. The trick is to buy them when they are being accumulated, which is what technical analysis is all about. Tracking winners is not as difficult as some are led to believe.
ECC: An Example
The stock that I am going to use as an example is ECC International, the top-performing NYSE-listed stock during the first quarter with a gain of 129.7%. Many of the universal principles of technical analysis as they apply to low-priced stocks are fully displayed in ECC. While the overall picture of ECC is one of a dramatic advance, investors would be served by studying the trend in ECC step-by-step.
ECC International (formerly Educational Computer Corporation) primarily produces computer-controlled simulators for training personnel to perform maintenance and operator procedures on military weapons systems. The U.S. Department of Defense accounted for nearly three-fourths of ECC revenue.
Over the past decade, the stock has sold as high as 145/8 (in 1983), and the stock trend has largely been bearish ever since. By late 1992, ECC had lost 88.8% of its value. At the lows of 15/8, there was very little investor interest in the company, to say the least.
Picking a stock at the exact low is more often than not a matter of luck. Lacking any clues from previous support levels, all an investor has to go on in terms of a technical pattern is usually a minor zigzag trend formation. Such a pattern developed in ECC as the stock rose off its lows during the last quarter of 1992.
However, in the majority of cases, the initial advance in a depressed stock is short-lived and not the start, for all intents and purposes, of a sustainable uptrend. The initial advance is more of an automatic rebound from oversold conditions stemming from the steep prior declines, rather than the start of a major bullish trend.
That initial surge in all likelihood is fueled for the most part by short-covering, rather than any conviction on the part of buyers over the prospects of improving fundamentals. In any recovery and uptrend, a stock has significant overhead resistance, a ready supply of sellers.
Indicators of “Resistance”
All readers have heard of resistance. Many investors tend to look at a previous high and say “that’s resistance.” However, a more substantive indication of resistance is indicated by previous lows.
Previous lows, at one time representing support, become the focal point of resistance once a stock moves to new lows. For instance, the lows during the summer of 1990, at 31/2, were to come into play several times in subsequent trend activity in 1992 and 1993. The first would stem ECC’s initial rebound.
During the initial advance from the September 1992 lows of 15/8, ECC advanced in an intermediate trend composed of a series of three minor advances, to a high of 35/8 in December of 1993, advancing right into the resistance at 31/2. Subsequently, the stock moved lower. The typical “corrections” in low-priced stocks following the initial rebound tend to be in the neighborhood of a 2/3 to 3/4 correction of the previous advance. With ECC, the stock would decline to 2.
In many low-priced stocks it takes time for the stock to base (to form a bottom) to develop the impetus for a major bullish trend. There certainly are a dearth of analysts following the stock, and the stock can be expected to vacillate for months following its initial rebound off its lows.
Investors might think of this phase in terms of a pendulum. The last decline carried the stock to 15/8. The initial upswing was from 15/8 to 35/8. The following downswing carried the stock to 2. The next upswing carried the stock back to 23/4, the following downswing to 21/8, and so forth.
Such a time when the stock is probing for equilibrium represents the developing accumulation phase in many low-priced stocks. The initial rebound from the lows can be very sharp, quick, and short-lived. However, many low-priced stocks like ECC will then tend to move from that initial sharp rebound rally to a more orderly pattern of accumulation in almost a “coiling” effect. And by being more orderly, investors have a much greater opportunity of buying right and having plenty of time to get on board.
ECC would advance in May from 2 to 23/4, then sell off in June to 21/8. The next advance would carry the stock to 31/4. The pendulum would keep swinging higher and higher on the upswings, and less and less on the downswings. The trend action was bullish.
Throughout the summer of 1993, ECC continued to demonstrate a gradual upward bias in its swings or waves. The stock was continuing to bob up and down, but at gradually higher levels. The resistance at 31/2 was still exerting selling pressures, but the support began to develop at higher levels—2, then 21/8, then 23/8, then 21/2. Throughout the summer and fall the stock was advancing in classic bullish trend pattern.
During October the stock rose right up to the edge of the resistance at 31/2 once again. After a few days hesitation, ECC broke out above 31/2. Once through resistance, the “mark-up” phase of ECC’s bullish trend began in earnest. For a few weeks the stock churned at the resistance represented by an important May 1991 low of 47/8, but then moved sharply higher in January.
ECC would pause in late January at 63/4. At first glance, 63/4 appears to be resistance as represented by the mid-1991 highs. However, those mid-1991 highs, as well as the hesitation in January, stemmed from the resistance created by ECC’s 1987 panic lows of 63/4. Panic lows can be extremely significant, and seven years later, in 1994, the stock was reflecting resistance at those lows. However, once through that important resistance level, ECC shot ahead dramatically, rising to 15.
Readers of my previous articles are already aware of my penchant for the details. I stress the details because stocks tend to show recurring trend patterns. When a stock is rising from its lows, say in the case of ECC, from 15/8 to 15, it does so in an orderly fashion, demonstrating typical trend characteristics, characteristics that tend to be formed by the interplay between support and resistance. While ECC would capture the Wall Street spotlight with its dynamic first quarter rise, it was demonstrating typical bullish trend development much earlier and at lower prices.
A Price Roadmap
The most effective means to stock market success is indeed to buy low and sell high. Technical analysis provides a reliable roadmap in enabling investors to buy early into an uptrending low-priced stock on its way to becoming a higher-priced stock.
While investors looking for more “exotic” applications that tend to dominate technical analysis today may be disappointed, readers who take the time to study the relatively simple process of trend development will find plenty of winners among low-priced stocks.