Let's get this out of the way from the start: The price of a stock does not matter. This is not to say that you should pay any price for a stock, but that whether a stock costs $5 or $50, it bears no relation to the underlying value of the security.
Some investors don't know this, and therefore believe that $5 JA Solar Holdings (Nasdaq: JASO) is "cheaper" than $50 Hewlett-Packard (NYSE: HPQ). Nothing could be further from the truth. In fact, JA Solar doesn't make any money (and therefore could be worthless), while a $50 investment in HP will buy you more than $3 per share in annual earnings (which are actually worth something).
Get right out of town
As it turns out, there are a lot of truly expensive stocks trading with sub-$5 price tags. That's because this segment of the market -- what the pros call "low-priced stocks," what laymen call "penny stocks," and what I call "stocks that cost less than a sandwich" -- is generally where stocks go to die.
AIG (NYSE: AIG) was there before undertaking a 1:20 reverse stock split to try to boost credibility, Sirius XM Radio (Nasdaq: SIRI) is there as it continues to burn through cash, and GM was there prior to declaring bankruptcy. It's so bad, in fact, that many mutual funds prohibit their managers from investing in these types of securities.
It's precisely because so many of the stocks in this segment are written off by the market at large as garbage, however, that you can find big winners.
This stock costs less than a sandwich
It was in the middle of 2007 that, in the course of screening for small-cap stock ideas, I first came across Female Health Co. (Nasdaq: FHCO). This maker of female condoms was then listed on the AMEX and trading for less than $3 per share.
While the stock was not without merits (it popped up on a screen looking for debt-free balance sheets, good returns on equity, and widening profit margins), I'm embarrassed now to say I dismissed it. It was truly small, free cash flow negative, and its core product sounded like a novelty.
Not so fast
Fast-forward one year and Female Health Co. came up again in conversation with a hedge fund manager friend. He owned the stock and was very high on its prospects. The stock was either going up, he said, or it would get bought out by a serious consumer goods company such as Johnson & Johnson (NYSE: JNJ) or Church & Dwight (NYSE: CHD) Although it was still trading on the AMEX for less than $3, I decided to give Female Health Co. a more serious look.
The product, as it turned out, was not a novelty, but rather a critical part of AIDS prevention efforts around the world. Further, FDA approval yielded a competitive advantage in that the governments and organizations engaged in these efforts can only purchase and distribute approved devices.
These facts meant that the company was now rapidly growing sales and generating significant cash flows relative to its market cap -- cash it was using to reward shareholders with share repurchases.
Finally, there was a catalyst in that the company was awaiting approval of a new second-generation product that carried significantly higher profit margins.
The market, however, had not caught onto any of this since most investors out there still saw what I saw at first: An AMEX-listed penny stock with a novelty product.
That's what makes a stock market opportunity
I, on the other hand, now saw real potential and estimated that Female Health Co. shares were worth approximately $5 apiece -- a near double from the then stock price. I bought and waited. While it took the market some time to catch on to Female Health Co.'s story, a combination of improving results and share repurchases meant that the price appreciation was near overwhelming when it finally did.
The shares traded all the way north of $7 in the middle of 2009 even as the rest of the stock market was collapsing, and, thanks to ongoing cash generation, the company recently declared a $0.20 annual dividend. That's a better than 3% yield at current prices and a better than 8% yield at my purchase price (something you won't normally get from a micro cap).
The moral of the story
I don't write all of this to brag about an opportunity you all missed (in fact, I believe Female Health continues to present compelling value). Rather, I write it to prove that there are some big potential winners out there trading for less than the price of a sandwich.
The problem, of course, is that they're hard to find and almost impossible to recommend to others (since they're liable to pop as soon as any attention is shined on them). This is why I've never been able to write about Female Health Co. at any great length anytime before on Fool.com.
That, however, is about to change. The Motley Fool is about to introduce a new research service focused exclusively on overlooked value opportunities, and it's going to limit the number of people who can access it in order to ensure that ideas as small as Female Health was a few years ago can be presented to members.
If that's something you're interested in learning more about, simply enter your email in the box below.
