When first I started learning about the financial markets in 2007, I was 12 years old. One of the first calculations I made was that you can buy more shares of the same company if the share price is cheap. Almost immediately, I figured out from talking to people I knew that had street smarts that the share price of the company you buy is just a unit of denomination and that your position value is what matters. This effect seems to have been lost on Robinhood customers, however, who pile into sub-$5 stocks on a continual basis. I wrote about this bias in my book–my earlier work isn’t as advanced as what I write on here, but is really helpful for beginning and intermediate investors.
For example, to buy one share of Amazon (AMZN) right now at the time of writing this is over $2300, but to buy one share of Ford (F) is around $5. However, share prices are more than a unit of denomination, they’re also strongly predictive of past company performance, and somewhat predictive of future performance. Amazon got to $2300+ by growing at a breakneck pace and kicking ass in every line of business they compete in. Ford got to $5 from decades of spinning their wheels and struggling. We know that there is both a strong time-series momentum and cross-sectional momentum effect in stocks. These both contribute to high and rising share prices. In short, winners tend to keep winning, while losers tend to continue losing.
Now let’s look at the top holdings of Robinhood customers, defined by the number of customers that own them.
Source: Robinhood.com
The top stock right now on Robinhood is literally a penny stock, and 4 of the top 5 stocks owned on Robinhood are less than $7 per share. While there are occasional opportunities in low-dollar stocks, Robinhood customers systematically select stocks that are cheap, simply because they’re cheap. They’re collectively propping up the stocks of a lot of struggling companies, which then see earnings-related reversion to their fundamentals. The flip side of the momentum effect is the disposition effect, where investors sell winners quickly and ride their losers to zero. This causes massive underperformance over time. Bottom line–unless you have a good reason to do so, it usually pays to avoid any stock trading for less than $10. There are successful investors who specialize in turnaround stocks, but Robinhood clients don’t fit that mold.
There’s another related myth that a lot of penny-stock promoters like to circulate, which is that successful companies today started out as penny stocks. They’ll even link to Yahoo Finance or Google and the stock charts will show that stocks “traded” for pennies in the past. This is almost always an illusion caused by stock splits and split-adjusted market data. It’s exceedingly rare for a stock to go from sub-$5 to over $50. It’s significantly less rare for stocks to go from $50 to $500, adjusted for splits. Most online brokers will show split data if you know where to look, which can help you understand what stocks traded for in the past. Fewer companies split their stocks now, meaning high share prices are even more predictive of momentum.
Conclusion
Don’t buy low-priced stocks because they’re low priced. One truism of the financial markets is that the highest-priced stocks are the most successful companies, and another is that winners in the stock market tend to keep winning. So, next time you’re looking for stocks to buy, pay special attention to those with high and rising share prices, because research shows that those are the stocks with the strongest future returns.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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