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The Ugly Truth About ‘Cheap’ Stocks Under $5

I am notoriously frugal. I reuse old plastic shopping bags as garbage bags, my family almost always prepares meals at home and I still drive around a 2002 Honda because it’s paid for and will probably give me another three years.

But one thing I will never skimp on is share prices. I buy a stock based on its underlying fundamentals, its corporate leadership and its growth trajectory. Whether it costs $1 or $1,000 a share is academic.

That’s because cheaper stocks have zero benefit in your portfolio. They are not easier to buy, and cheap stocks do not inherently have a better chance of making you more money. And aside from not doing anything extraordinary, they also have significant drawbacks.

Namely, the fact that they frequently trade on low volume and suffer high volatility. And if they don’t, they often are the playground for HFT robots and hedge funds.

So why would you focus on this kind of investment to the exclusion of everything else?

To be clear, I am not saying don’t buy cheap stocks — there are some good ones out there. I’m just saying don’t buy a company wholly based on its share price.

If you do focus only cheap stocks, demanding any of your investments have a price tag in the single digits first and foremost, the general profile of the kind of company you’re stuck with is very risky.

I screened data through Google Finance focusing on the current 1,533 stocks on U.S. exchanges that trade for under $5 a share (as of the open on Thursday, Nov. 29). And here’s how they look in aggregate.

No Dividends

Of the 1,533 stocks under $5, only 138 of them (roughly 9%) have a dividend of 1% or higher.

And of those that do pay dividends, some of those yields are obviously not built to last. Take Torch Energy Royalty Trust (NYSE:TRU), with a nominal yield of 85% based on a 2011 payday that has no hope of being repeated. Its big yield in Google Finance is just a trick of the screener, so the actual dividend payers are actually far less than even that 9% indicates.

Of course, this small list of 138 dividend stocks does include legitimate payers like Japanese bank Mizuho Financial (NYSE:MFG) with its 4.9% yield. But by and large the dividends aren’t there … or aren’t sustainable.

Crazy Volatility — Most Often to the Downside

Of those same 1,533 stocks, 401 of them have lost 30% or more in the past 52 weeks. That’s a stunning 26% of this investment class! Do you really want to take a 1-in-4 chance of a big loss like that?

Losers in the last year include daily-deal flop Groupon (NASDAQ:GRPN), which has lost 77%, and retailer RadioShack (NYSE:RSH), off almost 80%. That makes sense, after all, since a low price is often achieved after a big crash. Remember that any $5 stock that keeps going up will naturally move out of this universe over time, leaving you with a preponderance of stocks with momentum to the downside instead.

Of course, on the flip side 235 companies have a gain of 40% or more in the same period — about 15% of the group — to double the S&P 500’s returns in the same period. That includes media company McClatchy Company (NYSE:MNI), up about 200%, and online real estate firm ZipRealty (NASDAQ:ZIPR), up 140%.

But if the big losers outnumber the big winners roughly 2-to-1 in a decidedly bullish environment … what would happen if things head south?

Also, from a broader perspective, almost half of the stocks are included in the two groups above, of big losers and outsized winners. There’s nothing wrong with dabbling in fast-moving small-caps — but if you focus solely on cheap stocks without any stability to your portfolio, you will be overloaded with volatile and risky plays.

No Volume

On top of the long-term volatility, there’s the risk of short-term volatility due to many of these picks being illiquid. Only 212 of the 1,533 stocks under $5 — less than 14% — have an average volume of more than 100,000 shares daily. And a paltry 28 stocks have volume over 1 million shares!

A functional market always involves a number of buyers and sellers to prevent any one order from skewing results. It’s simply supply and demand — read up on the mechanics of “bid” and “ask” prices if you don’t know how this affects stocks — and in an illiquid stock, a market order of just 1,000 shares can often send prices swinging wildly.

If you enjoy this ulcer-inducing volatility, more power to you. But please use limit orders to protect yourself rather than placing an open-market order and letting your broker’s computer algorithm calculate the buy or sell price for you.

Low Price Means Low Profile

Perhaps most troubling of all is that low-priced stocks tend to be smaller offerings with much less analyst coverage and publicly available information. That leaves the door open for unexpected volatility — and in the worst cases, outright fraud.

One big reason is because major exchanges like the NYSE and Nasdaq have minimum share price of $1 — driving many cheap stocks to the pink sheets, where SEC filing requirements are much more lax. If you’re considering a cheap stock on the pink sheets, you will have far less information at your disposal to measure your investment — and pink sheets are a common playground for scam artists for that very reason.

And even when a company is on a major exchange, coverage on small issues tends to be very thin. The vast majority of Wall Street commentators, analysts and fact-checkers focus on widely held companies — so don’t expect the “smart money” indicators like upgrades/downgrades or price targets as you would with big-name stocks that garner a bigger price tag.

There are exceptions, of course. Nokia (NYSE:NOK) is a big stock with a $12 billion market cap, volume north of 50 million on most days and 17 analysts covering … and it trades for 3 bucks and change. But by and large, most small stocks do not fit this model.

Of course, some investors may contend that a low-profile stock is a good stock, because you could make a great find before Wall Street catches on. I suppose that’s true … but it doesn’t leave much room for error, especially if unscrupulous traders are playing games with a low-priced issue.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIPAs of this writing, he did not own a position in any of the stocks named here.

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