Not a bad strategy if you have guts of steel and solid analyst skills, I’ve made some killings on “Fallen Angel” stocks including K-Mart, Texaco (my first FA buy, when it crashed after the Pennzoil ruling) and LTV, but I’ve lost some in crap like Enron (I bought a thousand shares at around $3 the day before the Dynergy talks collapsed. After that, it was over: Never saw $3 grand just disappear like that in my life.)
You’re essentially looking for unpopular* stocks with middlin’-to-strong fundamentals, companys that are suffering a temporary hit in their stock price because of a turn of the business/industry cycle, bad press, or negative affects of unusual items.
To find candidates for research is pretty easy - with the amount you want to invest, find a table of all NYSE stocks and their last closing prices, sort by price, look at the least-costly stocks and take note of all the names that surprise you for being that low. This should give you a list of 10+ stocks to look at. Companies that are coming out of bankruptcy reorgs are worth looking at as well.
Then download all their latest 10-k’s, paying careful attention to statement of cash flows, unusual items, as well as the basic balance sheet/income statement info. If you find a company that is able to manage the downturn (that’s where the cash flow statements come in) and has a number of one-time unusual items (especially lawsuits: a company that drops 60% because it just lost some $11 billion judgment is ripe for buying (just ask Texaco)).
Decide on one. If you do your analysis right (or you get lucky), you’ll do well.
*Once you have some money, you can go for higher-priced unpopular stocks. Both Wal-Mart and Microsoft are languishing, though they’re pumping out earnings like nobody’s business. MS is particularly interesting because they’re in a transition period, everybody knows they’re in a transition period, and the stock has been sitting there, doing nothing for about 5 years now. Couple that with their large stock buyback program and there’s no reason why it shouldn’t be doing better… other than that it’s not popular.
Btw, “Fallen Angels” are not “penny stocks”, but they’re the closest to what you’re looking for: very low-priced stocks that offers a decent shot of earning high-returns in companies that have plenty of analyzable data.
Isn’t there a strong prejudice about all stocks that trade for less than $5.00/share? That’s about junk status. I think corporate CFOs try to keep their stock from sliding this low-I recall LM Ericsson went below $5.00-and the company did a reverse split! yes, penny stocks can net you fantastic returns-but most of these companies sink like a rock! You can also buy firms that are in bankruptcy-but that’s a real crapshoot! I also wonder about strong-earning firms like Microsoft, or Alcoa-nobody seems to have much interest in them.
It’d be a little more accurate to say “If you get lucky, you’ll do well.” Analysing the fundamentals may help you pick safe bets, but ultimately any single stock is a risky and unpredictable asset.
By default, of course. Even well-managed companies like GE or MS constantly risk becoming valueless due to forces beyond their control (or within: look at what happened to Enron or Barrons). And there’s nothing in what I wrote that suggested you could “beat” the market every time.
However, with knowledge and experience, you can win more than you lose. And you do this by seeking out value using many of the same principles found in the link.
“Fallen Angel” investing takes Graham one further in which you’re looking for severe differentials between the breakup value of the company* and its market capitalization. It assumes that, at times, the market can be completely irrational in its valuations and value companies far below their true worth. It’s different from “penny stock” investing in that you’re looking for well-established corporations who have fallen in a bad patch, but one that can be righted.
With penny stocks, you’re just taking a bet that the little company that fills the corner suite at that shiny new office complex down the road is going to take off - hell, it’s worse than Vegas, because at least Vegas posts odds. There are 500 slots in the Fortune-500, but over 10,000,000 corporate entities in the US: those odds come to 1:20,000. Better than the lottery Super Jackpot, but far, far worse than blackjack.
*Not the only way that you can value a company, of course, but it’s an example that easily understood even to the new investor: “breakup value” is what you are left with if you decide close up shop, sell the assets, and pay off the liabilities.
Corporate CEO’s (of publicly traded companies) have a strong prejudice against any dip in the stock price - even if it’s from $90 to $70. “Keeping the stock price up and growing” is, in fact, the major job task of the CEO.
You mention Ericsson. Not being a fan of foreign stocks I didn’t take any of it, but even with a reverse split… you realize that the stock was down to $.50/share but closed today at $37? Even a 10:1 split would’ve netted you pretty well: $10,000 invested in Ericsson at its 2003 low would now be worth over $70,000 today.
Also, I meant companies emerging from bankruptcy, not necessarily in bankruptcy. Wait until the reorganization is over and signed off by all parties before thinking about buying that stock: last thing you want is to be recapitalized out of your position!