Cheap has several possible meanings to stock market investors. A cheap stock can be one that trades at a low price. Other investors use the word “cheap” to indicate the stock is undervalued. Under that definition, a stock selling at $1,000 a share would be considered cheap if the investor believes the fundamental value of the stock is $1,500. In that case, they would believe they were buying assets valued at $1 for one-third off and paying $1,000 a share would be a bargain.
In this post, we will use the first definition and look at stocks trading below $10. Low-priced stocks are capable of delivering large returns with relatively small price moves. If a stock trading at $5 gains $1, for example, it provides a gain of 20%. A 20% move in a $1,000 stock requires a $200 gain. While the percentage gain is the same, it is often easier for a stock to move $1 than $200. Just a small increase in interest in a low-priced stocks could generate enough buying pressure to move the stock by $1.
However, low-priced stocks might be priced low for a reason, that reason being the stocks are not worth much. It’s possible a stock is trading for several dollars a share because earnings are low and expected to decline for the next few years or because the company is likely to go bankrupt. Ideally, we want to avoid these stocks.
To find low-priced stocks capable of delivering large gains, we screened for stocks trading below $10 that reported an increase in free cash flow (FCF) over the past twelve months and have performed in the top half of the market over the past six months. A number of studies have demonstrated these two indicators, growth in FCF and relative strength (RS), are strong predictors of future performance.
Many investors use indicators that tell them about the past. For example, the price-to-earnings (P/E) ratio generally uses reported earnings for the past twelve months. This is a snapshot of what has happened and by itself, earnings per share (EPS) tell us nothing about the future. Next year’s earnings could be higher or lower, depending on a variety of factors.
Finance professors have examined dozens if not hundreds of fundamental indicators. Their studies confirm that most metrics are backward looking. Mathematically, indicators like the P/E ratio explain a great deal about a stock’s historical performance but do not provide significant information about the stock’s future performance.
Among the few indicators that show a strong correlation with future performance is growth in FCF.
FCF is calculated using a number of values found in a company’s financial statements. Its calculation can seem relatively complex.
For now, the important point is that FCF is what a company uses to invest in its future and to reward its shareholders with dividends or share buybacks. In other words, FCF is needed to grow the company. Understanding that, it’s obvious why growth in FCF could be predictive of the future of a company.
Another factor researchers have found helps to predict a stock’s future performance is RS. This indicator compares a stock’s recent performance to the performance of all other stocks. Research has shown that stocks that were market leaders over the past six months tend to be among the market leaders in the next six months.
This also seems obvious once it’s highlighted to us. In sports, we find the team that is leading at halftime often wins the game. RS is a way of looking at the halftime score in the stock market. There is no guarantee the winners of the past six months will be among the winners in the next six months but they are often are. Researchers have documented a statistically significant relationship between performance in the two periods.
Our screen identified five stocks to consider:
MeetMe, Inc. (Nasdaq: MEET) is a social media technology company that owns and operates the MeetMe mobile applications and meetme.com. MEET provides users with access to a menu of resources that promote social interaction, information sharing and other topics of interest. These products are used for online marketing, allowing marketers to display their ads to targeted audiences. The company’s social networking products include Profile, Chat and Friends. Its social discovery products include Feed, which is the Company’s location-based stream communication feature, and Meet. The Company has approximately 4.97 million monthly active users and approximately 1.19 million daily active users.
Analysts expect MEET to earn $0.53 a share next year. Companies in the computer services industry have traded with an average P/E ratio of 24 in the past five years. If MEET trades at a discount to its peers with a P/E ratio of 15, the stock could trade at nearly $8. At that price, it could still be considered cheap.
Avon Products, Inc. (NYSE: AVP) is the well-known marketer of home and beauty products. Its products include personal care products, fragrances and cosmetics. Avon is especially well known for its business model which consists primarily of direct sales through independent representatives selling to friends and neighbors.
AVP is in a long-term downtrend. Based on fundamentals, the selloff appears to have reached an extreme.
Personal and household product distributers including AVON have typically traded at a market value equal to 1.5 times their sales. AVP is currently trading with a price-to-sales (P/S) ratio of 0.5. The stock could gain 200% before reaching the average valuation level for its sector.
Zynga Inc. (Nasdaq: ZNGA) makes social game services. Its product lineup includes Slots, Words With Friends, Zynga Poker and FarmVille franchises. ZNGA analyzes the data generated by its players’ game play and social interactions to guide the creation of content and features. The company has grown sales an average of 5% a year in the past five years while cash flow has increased at an average pace of more than 50% a year over that time. Cash flow is especially important in a business so dependent on new product development. With funds available to pursue growth, ZNGA’s stock price could increase as hit products are introduced. The stock is currently priced at about 1.5 times its book value while the long-term industry average price-to-book (P/B) ratio is 2.8. At that value, ZNGA could be worth more than $5.30 a share.
Acacia Research Corporation (Nasdaq: ACTG) is engaged in patent investment, prosecution, licensing and enforcement activities. The company partners with inventors and patent owners and seeks to generate revenues by granting intellectual property rights for the use of patented technologies. ACTG also assists patent owners protect patented inventions from unauthorized use, at times by filing of patent infringement litigation.
Revenue will vary based on the success of the company’s strategy. However, cash flow should allow the company to continue operations throughout lean times. Intellectual property makes up a large part of the company’s book value. At a P/B value of 1.5, a steep discount to the company’s historic average valuation, the stock could be worth $7.90, 25% above the current price.
Chegg, Inc. (NYSE: CHGG) is a connected learning platform. The company helps students study for college admission exams, find the colleges, get grades and test scores while in school, and find internships that allow them to gain skills to help them enter the workforce after college. It matches domestic and international students with colleges, universities and other academic institutions in the United States. Once in college, it provides a range of products and services to help students. The company offers a print textbook library for rent and sale both on its own and through its strategic partnership with Ingram. It also offers eTextbooks for rent and sale. It also provides live tutors to students online, through its Chegg Tutors service. It provides access to internships to help students gain skills that are critical to securing their first job and the company also provides online writing tools, such as EasyBib, CitationMachine or BibMe.
Analysts expect CHGG to report earnings per share of $0.10 this year with growth to $0.29 next year and $0.59 in 2018. Based on expected earnings growth, the stock could trade at $8.70, almost 30% higher than the recent price.