If making money in the stock market were as simple as buying low-priced stocks, the Forbes list of billionaires would be loaded with penny-stock traders, instead of long-term investors and incredible entrepreneurs.
The simple reality is that for every penny stock that "made it," like Monster Beverage, there are perhaps thousands of penny stocks that zig and zag but ultimately end up at zero.
Time and effort is best spent finding winning companies that trade at reasonable valuations, not low per-share prices. Here's why these three Fool.com writers believe Square (SQ 0.51%), Bank of America (BAC 1.59%), and Capital One Financial (COF 0.26%) are a better bet for your portfolio.
This stock is up 390% in 18 months but still has tremendous potential
Matt Frankel (Square): The main problem with investing in penny stocks is that you're taking a huge gamble. Many penny stocks' underlying businesses don't have any real revenue, and some are outright scams. Financial disruptor Square has penny stock-like growth potential, but with an established business with excellent growth.
Square's core business of payment-processing hardware is absolutely thriving, and in addition to its original target of small business customers, the company's recently introduced Square Register standalone point-of-sale system is bringing more medium- and large-sized businesses into Square's ecosystem.
Speaking of Square's ecosystem, in addition to payment hardware, Square's Cash app is gaining major traction and is among the most popular peer-to-peer payments app. Square Capital, the company's business lending platform, is making more loans every quarter. And that's just naming a few of Square's products.
Square's revenue grew by 43% last year, and instead of slowing down, analysts are expecting this growth to accelerate this year. And considering Square's addressable market, it's not surprising. In fact, an analyst from Credit Suisse wrote that "we believe Square has penetrated only about 1% of its addressable opportunity." So even if Square can capture, say, 5% of its potential, the stock could still have a long way to climb.
In a nutshell, Square is a great combination of the growth potential investors hope for when buying penny stocks and an actual rock-solid business.
Image source: Getty Images.
Long-term returns you can bank on
Sean Williams (Bank of America): Sure, you might throw a few chips on the table and win money once in a while with penny stocks, but they're more akin to gambling than investing. If you want a smarter place to park your cash, consider a tried and true winner like Bank of America.
I know what you're thinking: "Wait, isn't this the same Bank of America that nearly collapsed during the financial crisis, and then tried to charge members to use their debit cards a few years later?" Well, yeah, it is. But it's also a banking giant that's come a long way from where it was even five years ago.
Now that we've moved past the numerous fines and settlements Bank of America paid that were primarily tied to its Countrywide Financial acquisition in regard to mortgage practices, we're getting a much clearer picture of what the company is capable of.
During the second quarter, Bank of America saw net income jump 33% (43% on an adjusted EPS basis), driven by lower corporate tax rates and higher interest rates, while total loans and deposits, the backbone of banking, rose a very healthy 7% and 5%, respectively.
In particular, Bank of America tends to be more sensitive to interest rate fluctuations than of the money center banks. Its earnings presentation calls for an additional $2.8 billion in net interest income (most of which will go directly to its bottom line) if short- and long-term interest rates rise by 100 basis points over the next 12 months. Given a somewhat hawkish Federal Reserve of late, this isn't out of the question.
And while traditional banking activity has picked up, the company has seen its legacy nonperforming loans dwindle. Even with a modest $88 million increase to net charge-offs to $996 million, representing a low net charge-off ratio of 0.43%, nonperforming assets declined by $946 million to $6.18 billion.
All told, we have a money-center bank that raised its dividend by 25% and just pledged to buy back over $20 billion worth of its stock over the next 12 months. Let's see a penny stock do that!
More than just a credit card
Jordan Wathen (Capital One Financial): This company may be best known for its credit cards, but Capital One is a true consumer and commercial banking institution. About 47% of its loan portfolio comes from credit cards. Commercial and consumer loans -- autos, primarily -- make up 29% and 25% of its portfolio, respectively.
Capital One's main advantage is having a data-driven approach to credit. From a standing start in the 1990s, it issued roughly 50 million cards in just eight years, using data to target households one by one with specialized offers, an innovation that was others only later copied.
That approach hasn't changed. The company isn't afraid to test new products, nor is it afraid to cut and run from losers. Last year, it made the difficult, but economic, decision to leave behind home equity lending, for example.
Capital One has also invested heavily to build out a deposit franchise, which is paying dividends as interest rates rise. Though it pays a competitive market rate on savings deposits of roughly 1% per year, deposits are the least expensive way to fund its balance sheet. It's better to pay a market rate for deposits than a market rate on corporate bonds.
Shares trade at less than 9 times consensus earnings estimates this year, as investors worry about an eventual rise in charge-offs following several years of below-average credit losses. But given Capital One's below-average loss experience over its history, especially in the depths of the financial crisis, and its beefed up allowances for loan losses, I believe Capital One can thrive even if loan losses tick up from near historical lows.
