While the current recession has seen a number of large-cap stocks fall into the penny stock range, that doesn’t mean they’re still a safe bet. In fact, there are a lot of broken stocks out there worth avoiding at all cost. At the same time, a recent study shows that historically, small-cap stocks blaze a leading trail out of a recession.
I use to hate going into stores and seeing the hand written notice, “Nice to touch, nice to hold, if you break it, consider it sold.” There’s no basis for my hatred, it just annoyed me.
Though, it was a life lesson when my father knocked over a coffee mug tree stand display; breaking most of the contents. He ended up “buying” a couple dozen mugs. The only salvageable one was “World’s Best Golfer”. He isn’t.
Unfortunately, as tax payers, we learned recently that our money is being used to take serious stakes in broken companies like General Motors and Chrysler. GM followed Chrysler into bankruptcy earlier this week; ending its 93 year stay on the stock market with a share price of $0.75. A far cry from its $100 share price in 2000.
Based on the last trading price, GM’s market capitalization was about $457 million; just one-tenth of its 1929 market cap of over $4 billion. And a far cry from its $60 billion valuation at the beginning of this decade.
Anyway…thanks to the recession…and maybe the odd bad corporate decision made at GM, the federal government is set to own 60% of the new and improved GM. The Canadian government will have a 12.5% stake in the company and the UAW a 17.5% hand.
All told, the government, union and other partners will own 90% of GM. The remaining 10% is left to former bondholders, who paid a princely $27 billion for the right.
For the record, had the governments not stepped in, employees and suppliers would have gone unpaid. If GM and Chrysler had liquidated, their supply base would have vaporized…taking Ford down with it. It’s more complicated than that…but it’s a good barrier to entry.
The point is…the recent recession has been a not so gentle reminder that blue chip behemoths are not a sure bet. It’s also worth noting that not all penny stocks are chafe waiting for the scythe.
In fact, there are a large number of unbroken penny stocks out there worth padding your investment portfolio with. While some excellent penny stocks were unnecessarily dragged lower this past autumn with the rest of the world markets, there are others that bucked the trend.
In general, small cap value stocks have been the poorest performers so far this year, but recent trends show they could be the first to rebound if the economy improves. Penny stocks can also follow the same patterns as small cap stocks. During economic downturns (recessions) investors turn to safety and liquidity and shun so-called riskier markets. Russell Investments recently looked at the stock market’s performance during the last five U.S. recessions (going back to 1980); their research uncovered clear trends in value stock behavior.
On average, "value has underperformed relative to growth during periods of economic contraction." Further, "This relative underperformance has reversed almost immediately when the economy bottomed out and turned upward, and value has markedly outperformed growth in the early periods of economic expansion."
Most significantly, the Russell report found that, "This pattern has been strongest in the small cap segment of the market."
One analyst ran numbers on U.S recessions going back to 1931. He noticed big performance differences between large cap and small cap stocks during recessions and recoveries. There was less of a gap between value and growth stocks. “Small cap stocks very much lead out of a recession,” he said.
What are “value stocks”? According to Investopedia, a value investor believes that the market isn't always efficient and that it's possible to find companies trading for less than they are worth. “Growth” stocks on the other hand are shares in a company whose earnings are expected to grow at an above-average rate relative to the market.
Many penny stock investors are a mix of both. We like to look for value stocks that are going to outpace the market. An oxymoron for seasoned investors that shun penny stocks – but it’s a mantra many penny stock investors live by.
Why? Because many investors believe value stocks are “cheap” for a reason. And…many equate penny stocks with being cheap. Fortunately, correlation is not causation.
