Penny stocks are tempting because it seems easier for a stock priced at $0.10 per share to double than one at $100. But what really matters in terms of a stock's potential is the value of the whole business, not the price of each share.
Below, three Motley Fool investors lay the case for First American Financial (FAF -0.69%), White Mountain Insurance (WTM 2.64%), and Hanesbrands (HBI -0.82%) as better bets than the prototypical penny stock.
Find a home for your money
Dan Caplinger (First American Financial): It's easy to invest in big banks and other well-known financial institutions, and they make smarter investments than penny stocks. But looking at niches within the financial industry can also unearth some interesting plays. First American Financial is a big player in the title insurance space, profiting from the fact that the vast majority of home purchase and refinancing transactions require a financial institution to provide financial protection against the possibility that some third party will challenge the seller's ability to transfer full ownership rights to the buyer.
As you'd expect, First American's business is largely dependent on the state of the mortgage market, and the recent rise in interest rates has had a dampening effect on the number of refinancing transactions that come through its doors. Yet refinances are a relatively low-margin business for First American, and the strength of the real estate market for both residential and commercial property has provided a steady flow of new-purchase deals that bring in higher insurance premiums. With the stock having already seen some downward pressure as investors start to fear the worst from a rising rate environment, those who think that the bearish sentiment is overblown should take a closer look at First American Financial and its long-term prospects within the lucrative title insurance niche.
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Don't let an $800 share price scare you away from this steady insurer
Sean Williams (White Mountain Insurance): Though penny stocks might be alluring, a financial guarantee insurer with a share price of more than $800 looks to be a far smarter bet to this investor. That company is White Mountain Insurance.
White Mountain's lure for investors is that it has multiple channels to make money, as well as significant pricing power that's kept it steadily growing throughout the years.
The company's two primary operating segments are its financial guarantor HG Global/BAM and insurance and advertising technology subsidiary MediaAlpha. On a year-over-year basis, BAM ended with $747.4 million in guaranteed assets, most of which are fixed maturity investments (e.g., municipal bonds), representing a roughly $70 million increase from the prior-year period. According to Sean McCarthy, CEO of BAM, the company's 2017 results benefited from stronger premium pricing, larger average transaction size, and improved risk-adjusted pricing.
As for MediaAlpha, the company delivered strong organic growth in 2017, with EBITDA (earnings before interest, taxes, depreciation, and amortization) jumping from $7 million in 2016 to $11 million in 2017. In October, MediaAlpha also acquired assets from Healthplans.com, giving it access to domain names, advertiser and public relationships, and traffic acquisition counts, of various health, Medicare, and life insurance businesses.
Along with solid organic and inorganic growth, financial guarantors like White Mountain Insurance have little issue passing along premium price hikes. Though losses are inevitable as an insurer -- which means investors have to understand a company like this is meant to be a long-term holding, not a timed short-term trade -- White Mountain is able to use an increase in payouts to justify premium hikes. Even when there's a lull in payouts, White Mountain can use the expectation of a loss event in the future as reason to lift premiums.
Lastly, White Mountain has done well by its shareholders. Last year, it repurchased more than 18% of its outstanding shares, returning $724 million to its shareholders, which helps boost earnings per share and makes each remaining share scarcer. It may not be the most exciting business model, but it appears to be a much smarter investment than a penny stock.
A wager on T-shirts and underwear
Jordan Wathen (Hanesbrands): People often turn to penny stocks for high-risk, high-reward investments. With that in mind, I view Hanesbrands as a high-risk, high-reward play on the apparel business, without all problems that typically plague penny stock issuers.
You've likely purchased a Hanesbrands product before, as it makes its money selling under familiar names including Hanes, Champion, Wonderbra, and many more. It's unique in that it manufactures more than 70% of the products it sells in its own facilities, whereas others outsource the actual production to third parties, giving it more power to control costs.
Shares of Hanesbrands trade for just 12 times earnings guidance for 2018, as investors worry about how a general decline in the retail industry will play out for apparel makers. It's a fair concern, as a majority of its sales are derived from brick-and-mortar stores. Walmart and Target are its largest customers, responsible for 31% of its sales in 2017 on a combined basis.
While the slump may be a near-term challenge as retailers cut back on how much inventory they hold, it's my view that its brands can stand on their own and sell through, whether it's online or in store. Its portfolio of brands generates a tremendous amount of cash, which can be directed to acquisitions, share repurchases, and debt reduction. I view it as having more upside potential than downside risk, but be prepared to go on a roller-coaster ride -- the company is very comfortable with a lot of debt on the balance sheet, making for a very volatile stock price.
