If, at the turn of the millennium, you bought shares of Middleby Corp for less than $1 each, you'd be rich today, since shares now trade hands for more than $100. But for every runaway winner like Middleby, there are perhaps thousands of losers -- companies that zig and zag up and down before finding themselves in bankruptcy court.
Speculating in penny stocks is the financial markets' equivalent to investing in lottery tickets. Most turn out to be losers, while a few generate returns high enough to tempt otherwise rational people to take risks they'd never otherwise take.
Rather than gamble on the next big penny stock, investors would do well to buy quality companies worth owning for the long haul. In the article below, three Fool.com contributors make the case for BofI Holding (NYSE:AX), Jefferies Financial Group (NYSE:JEF), and The Travelers Companies (NYSE:TRV) as stocks to consider adding to your portfolio.
This fast-growing bank beats investing in penny stocks
Matt Frankel (BofI Holding): Think of the reasons people buy penny stocks -- smaller companies with chances of huge returns. The problem is that many penny stocks are either not revenue-generating businesses, or are flat-out scams.
Internet-based bank BofI Holding (which stands for "Bank of Internet") is a smaller company with a $2.6 billion market cap, and lots of potential for growth, but with a well-established business with excellent fundamentals.
With about $10 billion in total assets, BofI is a fraction of the size of the largest U.S. banks, some of which have assets in the trillions. However, the bank's growth has been tremendous. In the past year, net interest income is up by 32%, earnings per share grew by 27%, and the bank's loan portfolio grew 15%. And, the bank's now-exclusive partnership with H&R Block to provide the Refund Advance loans helped it produce an impressive net interest margin of 4.77% in the most recent quarter.
Here's the best part of BofI: Because it doesn't have physical branches, it has a massive cost advantage over other banks. This allows it to run an extremely efficient and profitable operation compared to other banks -- its return on equity (ROE) of 22.8% is more than double the industry benchmark, and its efficiency ratio of 32.4% is among the best in the business. Not only that, but it allows BofI to pay higher interest rates on its checking accounts and other deposit products, which gives it an advantage when it comes to bringing in new money.
In a nutshell, BofI has the growth potential investors often hope to find in penny stocks, but without the drawbacks.
Get in on this transformation
Dan Caplinger (Jefferies Financial Group): The investment brokerage sector has started to heat up lately, and as the markets have gotten more turbulent, more investors and companies have decided that getting help with their investing and investment banking needs is worth the effort. With a full range of investment products as well as services in areas ranging from wealth and asset management, investment banking, and trading in stocks, bonds, and commodities, Jefferies gives considerable exposure to the opportunities that the financial markets offer right now.
Recently, the company, formerly known as Leucadia National Corp, decided that it would focus its attention primarily on Jefferies, choosing to sell off most of its stake in its other major asset, the National Beef meat packing and processing business. In doing so, Leucadia also changed its name, making it clear that the company intends to become a powerhouse in financial services.
Shareholders hope that the move will get the market to recognize the value of Jefferies more fully, because right now, the stock overall undervalues the company compared to its book value. Such situations are increasingly rare, and as conditions keep improving in the investment banking arena, this company is likely to reap rewards from its strategic shift.
Bet on this cannibal
Jordan Wathen (The Travelers Companies): This insurance company is slowly taking itself private by buying back stock at a breakneck pace, putting on a seminar in how great insurance stocks separate themselves from the rest of the pack.
Every year, insurance companies are faced with a difficult decision: Use their earnings to write more policies, or send cash back to shareholders in the form of dividends and repurchases. Few balance the choice between growth and capital returns as well as The Travelers Companies.
This insurer isn't fast-growing, since premiums have grown at an annual compounded rate of just 2% since 2008. But because The Travelers Companies has aggressively repurchased stock, its earnings power on a per-share basis has soared. Each share now represents more than twice as much ownership of the business as it did just a decade ago.
Capital returns also reward shareholders indirectly. With less capital to support policy growth, The Travelers Companies is forced to be highly selective about which risks are worth underwriting and which are not. Being picky has enabled it to generate an underwriting profit in nine out of the last 10 years, a feat few insurance companies can come close to matching.
Shares of The Travelers Companies trade for about 12 times my estimate of its normalized earnings power. And while profits will ebb and flow from quarter to quarter and year to year, I think there are few better bets to buy and hold for the long haul.