The "Cheap Stock" Myth
One of the most common questions we get from Maendel Wealth clients is "Some portfolio holdings seem so expensive, so it seems those companies and funds must not have room to grow, right? Shouldn't we want to invest in "cheaper" holdings?"
Let’s get this myth out of the way from the get-go: a stock’s price has nothing to do with the value of its shares. That’s because a stock’s price is determined by two factors:
- The company’s total market capitalization, which represents the aggregate value of the entire company, divided by...
- The total number of shares of common stock that investors own, often called its shares outstanding.
Put those things together and a large company with a small number of shares outstanding might have a high stock price while the exact same company with a greater number of shares outstanding will have a lower stock price. And neither of those scenarios will tell you anything about the underlying quality of that company’s business, which is what ultimately determines your long-term investing returns.
On its own, a stock’s price cannot tell you anything about its potential as an investment.
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You've most likely come across the market phenomenon known as a stock split, where a company decides to increase its number of shares outstanding by issuing additional shares to its current shareholders. The result, of course, is a lower share price, which might nudge investors toward initiating or adding to their positions incrementally.
Though the most common stock split ratios are 2-for-1 or 3-for-1, Netflix (NASDAQ:NFLX) completed a 7-for-1 split in 2015. Overnight, every share of Netflix which had been worth slightly more than $700 became 7 shares each worth a bit above $100. This didn’t change the market capitalization of Netflix, but many investors who previously had felt priced out now viewed Netflix as more affordable and accessible in smaller amounts.
The second faulty assumption about lower priced stocks is that they must belong to smaller companies. Though it is true that some analysis indicates small cap stocks have outperformed their large cap brethren over the last century, this classification is far from enough to declare long-term superiority as you pick stocks to invest in. Smaller companies might have a longer runway for growth, while larger companies might enjoy greater competitive barriers and economies of scale. In the end, great businesses can exist at any share price or market capitalization.
Why Does This Matter
You may think that shares can more easily gain in value if they’re at a lower price. (Plus, our caveman brains experience something oddly satisfying by owning 100 shares of a company instead of 2 shares of another, even though the latter might be a better investment.*) After all, a $25 increase on a $25 stock is a double, compared to the same $25 move on a $250 stock. So, you might think you’ll make more money with that $25 stock than with the $250 stock. The trouble with that thought, however, is that stock prices move in percentages, not dollars.
Go ahead and look up any two companies with vastly different stock prices during trading hours. You’ll see that while the dollar amounts for the day’s change are quite varied between the two, the percentage amounts might be pretty similar.
Let’s say they’re both up 1%, for instance, even though for one that means a daily increase of $0.20 (a $20 stock) while for the other that means an increase of $2.50 (a $250 stock). If you have $1,000 invested in both, you’ve gained the exact same amount in each: $10.
Because the investment amounts and returns were identical, you see the same total gain no matter how many shares you own. Whether this hypothetical $1,000 investment might buy 50 shares of a $20 stock or 4 shares of a $250 stock, the more important decision is choosing companies that we think will earn higher long-term rates of return for the amount you have to invest.
So we hope we’ve done a little bit of myth-busting here. To recap:
- Lower-priced stocks do not necessarily go up any more quickly than higher-priced stocks.
- The number of shares you buy depends on the way you wish to apportion your portfolio positions.
Great businesses can exist at any share price or market capitalization.
If you'd like to learn more about how we can help you towards your wealth building and life goals, give us a call or a quick email. Do you absolutely need a financial advisor? Maybe not, if you have 40 hours a week to devote to the topic, but most of us have families, careers and lifestyles that are demanding, and (let's face it) more fun. At Maendel Wealth we firmly believe that having a great advisor can help make good things happen sooner for you, while freeing up your time and energy for things you love and do best.
Many of our valued clients started out right where you are now. Let's talk!
*neuroscientists have actually measured higher dopamine "pleasure" responses from subjects who bought more shares of a low price stock versus the same total dollar amount of higher priced shares, which is not rational. The discipline of Behavioral Financal Advice helps us identify and compensate for these potentially destructive investor behaviors. Find out more on our website here: How a Behavioral Financial Advisor (BFA™) benefits You