This Stock Is Cheap -- or Is It?

Bed Bath & Beyond (Nasdaq: BBBY  ) is one of the truly remarkable success stories of the past 15 years. Back in January 1993, Bed Bath & Beyond was still a small company that had not yet scratched the surface of its potential. Its shares traded for just $2. After years of growth, the stock now trades for $26.

That 1,200% gain illustrates the profit potential of investing in promising small companies. It also goes to show that if you want Bed Bath & Beyond-like gains, you need to look for stocks trading for $1 or $2 -- or definitely below $5. Just take a look at this list of winners since 1993 and their stock price back then:

Company

Gain Since Jan. 8, 1993

Stock Price on Jan. 8, 1993

Dell (Nasdaq: DELL  )

2,781%

$0.72

Caterpillar (NYSE: CAT  )

1,191%

$5.20

Time Warner (NYSE: TWX  )

8,174%

$0.19

Legg Mason (NYSE: LM  )

1,453%

$4.43

Lehman Brothers (NYSE: LEH  )

1,364%

$3.80

Say it with us: No, no, no!
Here's where we pull back the curtain: All of those Jan. 8, 1993, prices are adjusted for stock splits and -- in some cases -- dividends. While Bed Bath & Beyond was a small company back in 1993, it still traded for $32 per share. Dell traded for $46, Caterpillar for $57, Time Warner for $26, Legg Mason for $26, and Lehman Brothers for $17.

So we hope we've done a little bit of myth-busting here. Namely:

  1. Lower-priced stocks do not go up any faster than higher-priced stocks.
  2. Lower-priced stocks are not necessarily cheaper than higher-priced stocks.
  3. Lower-priced stocks are not necessarily smaller than higher-priced stocks.

By itself, a stock's price cannot tell you anything about the value of the underlying company or its investment potential.

That's why Middleby, a stock that's returned more than 600% for subscribers to our Motley Fool Hidden Gems small-cap service, can remain a promising $1 billion small cap even though it trades for north of $60 per share.

You cannot beat this price
Myths about the meaning of stock prices abound, and catering to those myths may be one of the reasons Middleby recently split the company's shares. But we encourage Middleby's leaders to stop worrying about the stock price, save the time and money required to file the necessary stock-splitting paperwork in the future, and instead continue to focus on allocating capital efficiently and growing the business for the long term.

That's what shareholders should care about. If the business is succeeding, the stock will follow -- regardless of whether it's starting from $5, $50, or $500.

The Foolish bottom line
We readily admit that small companies, as measured by market caps of $2 billion or less, are for many reasons likely to offer better returns than large companies going forward. So, if you're looking for stocks with the most potential for outsized returns, start with small caps -- you'll find that a more productive starting point than "low-priced stocks."

Also look for key traits of the market's biggest successes:

  1. Cheap valuations relative to a company's earnings or cash flows.
  2. Tenured managers who own a significant number of shares.
  3. Growing operations in a profitable niche.

And if you can find a company that meets these criteria, it's worthy of your research, no matter what the stock price. After all, this simple framework is often how we start our research at Motley Fool Hidden Gems. It helped us find Middleby and 50 more recommendations that are beating the market by 18 percentage points on average.

If you'd like to take a look at the stocks we're recommending today, click here to try Hidden Gems free for 30 days. There is no obligation to subscribe, and you might just find a bargain trading for $50 per share.

This article was originally published on Feb. 13, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned; Brian Richards doesn't own any, either. The Motley Fool owns shares of Bed Bath & Beyond. Dell, Bed Bath & Beyond, and Legg Mason are Motley Fool Inside Value recommendations. Dell, Bed Bath & Beyond, and Time Warner are Stock Advisor picks. The Fool's disclosure policy would like to remind you that when in Rome, price is what you pay.


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