Forget Penny Stocks — Here's the Best Way to Invest $20

Chris Hill: Hey, we’re coming to you from Fool global headquarters in Alexandria, Virginia. I’m Chris Hill, joined by Bill Mann and Jason Moser. Thanks for being here, guys! Jason Moser: Thanks for having us! Bill Mann: How are you, Chris? Hill: We’re going to be taking your questions. We’re going to be talking about investing for not a lot of money. And if you want even more information, we’ve got a free starter kit that has five top stocks to get you off and running. You can find it at fool.com/start, so check that out.  Jason Moser, let me start with you. Penny stocks are so attractive. I know they’re bad for me, but they’re so attractive. I can get a lot of shares. And I like having a lot of shares, because there’s nothing super fun about buying one or two shares of a company. And, look, if a stock’s at $0.50 and it goes up a quarter, boom, I’ve made a 50% gain. Moser: Well, I think you have keyed in on the lure of the penny stock, right? It’s a siren song that is difficult to resist because of that concept, that it’s very easy to go from $0.10 to $0.20. I mean, anybody can do that, right? Or $0.50 to $1.00. The problem is, we have to remember, a stock is ultimately a representation of an underlying business. And in most cases with these penny stocks, there’s not really an underlying business. So, getting from $0.10 to $0.20 sounds very easy, but it’s extremely difficult to do. But I think by nature, most people — and I’m probably in this camp, too — secretly want to get rich quick. We want to get rich quick, there’s just no way to really do it. And so, I think there are some qualities there that make it very difficult to resist, but the longer that you invest, the more you realize that hey, it’s actually kind of fun to buy one share or two shares because you know you’re getting a really good underlying business. Mann: Chris, stocks are priced where they are because of a structure from the market. It used to be that you could buy shares at a round lot, which was 100 shares, for cheaper than you could for what were odd lots. If you bought 63 shares of something, you paid more and brokerage costs. So, when you see shares that are below $10, it kind of signifies that something’s actually wrong with the business. Now, that doesn’t really exist anymore. You’ve got stocks that are trading at thousands of dollars a share. But there still is this belief or the structure that you want shares that are priced above $10. And that’s when you start to see businesses that are more reliably … what’s the word, real? Moser: Another thing to consider, too, is, I think a lot of people, they’ll look back at the history of charts with companies like Amazon or Walmart, name a business that’s done really well over long stretches of time, and they’ll point out periods of time where the stock was $0.50 or $0.25. They’re not recognizing the fact that those are adjusted prices, right? When you talk about either share splits or dividends or whatever it may be, remember, oftentimes, that’s an adjusted price. It’s not reflective of the actual price at that point in time. Hill: One last thing I’ll throw out there. Particularly when you’re starting out, you’re not necessarily thinking or even caring about the marketplace where these stocks are being sold. So, you don’t care if it’s the New York Stock Exchange or the NASDAQ. And a lot of these penny stocks, Bill, are over the counter, they’re thinly traded. And, to go back to the point you were making, I mean, the underlying structure of a lot of these penny stocks means that you are, as an investor, set up to fail. Mann: Yep. Every company really wants to be on the NASDAQ, or wants to be on the New York Stock Exchange. So, whenever you see a company that’s a penny stock, your first question ought to be, why is it there? Why is this company trading where it is? It’s not because they want you to be able to buy a bunch of shares. It’s usually because something bad has happened, or there’s a deficit that the company has in its operations that you probably ought to be aware of. Because if you buy 10,000 of something at $0.50 and it goes to zero, you’ve lost just as much money as if you bought something at a much higher price and it goes to zero. Hill: Alright, I know you guys have a couple of stocks that folks can put on their watch list. We’re going to be getting your questions in just a few minutes. Let’s talk about, if not penny stocks, what then? What should we be looking at? Because, particularly when you’re starting out, Jason, chances are you don’t have a lot of money. So, the underlying motivation of, “Hey, I’m looking for something for not a lot of money,” how do investors go about doing that if we’re saying right out of the gate, we need you to ignore the penny stocks? Moser: Well, yeah, and I mean, I think a time ago, this probably would have been a little bit more of a relevant question. I think the nice part about today is, because we have fractional shares and a lot of different ways to purchase fractional shares — I mean, it used to be a lot more difficult, in many cases, to buy shares of a company. And now, even though Amazon is trading at $2,000 a share or whatever, there are a lot of brokerage houses that will allow you to buy fractional shares of companies. So, even if you only have $20, $30, $40, $100, you can still get that money to work right away. And I actually had this question from a friend on Twitter just the other day, asking, he said, “Listen, I typically have $20, $30, $50 at a time. Should I be waiting and saving that money up?” A time ago, we would have said, make sure that your transaction fee represents no more than 2% of your overall cost there. Now everybody’s hit that finish line of zero dollars in transaction fees. So, you can pretty much buy whatever you want. And with fractional shares, in many cases, you don’t necessarily have to buy the entire share if it’s a business that you like. So, it really does all just come back to what we do here, and this business- focused mentality of investing, and just looking for good businesses. You can really put that share price more out of your mind now than ever before. Mann: Now, what you want to ask yourself is how the brokerages make money, in any case. It is the fact that, many of the big brokerages, when you buy whole shares, it’s $0 for the trade, which is fantastic. Fractional shares are actually a service that a lot of brokers provide. And there do tend to be fees that come along with it. Stockpile maybe is the best of the breed, and it’s $0.99 for a fractional share. So, you still do need to be a little bit careful, although $0.99 is not a lot of money. If you do the math on that for a $20 investment, that still comes out to be 5% of the investment. Moser: Absolutely. And don’t forget about DRIP, either, right, another way for fractional shares is that dividend reinvestment program. A lot of companies sponsor them, some brokerages do as well. But you can just keep on reinvesting the dividends that you get paid from those dividend payers. Mann: That’s one of the first things that The Motley Fool did. Moser: Well, yeah, and that’s been going for a while. It’s a tried and true method for sort of that fractional share purchasing.  Mann: That’s right. Hill: We were talking about this the other day. It’s completely natural to look at a stock in terms of the stock price. Right off the bat, that’s the first thing I want to know. What’s the stock price? We were in a conversation, and it wasn’t you and it wasn’t me, it was the third person, who won’t get the credit here — Moser: It wasn’t me either.  Mann: Let’s see how smart it was. Hill: — who said, the first thing I look at is the market cap, because I want to know the overall value of this company. And I think that, again, for people who are just starting out, knowing that you can avoid penny stocks, you can get fractional shares, looking less at the share price and more at the valuation, because you can look at entire companies, and there are what we like to consider as cheap stocks. Maybe they’re not under $20 a share, but, you look at the valuation, and it actually is trading at a discount. What are one or two things people should look at when they’re looking to figure out, “OK, I see the stock price, I see the market cap, is this an expensive stock? Or, on a valuation basis, is this cheap?” Mann: Yeah, I think one of the things that you really need to pay attention to — and when we talk about penny stocks, we’re talking about really two separate things. One is companies that are trading below $1 share, but then also, you have companies that are trading, let’s just take a number that’s not quite at random, below $100 million in market cap, for the entire company. In most cases, companies that are $100 million and below that are public have at one point been a much larger company than they are now. And so, yes, I totally agree. And market cap is probably a much more important way to determine actually the expense of a company, if you will, like, what is being paid for the company. Long-term, you really want to think about, what’s this company going to be doing to make more money? Because small companies to big companies need to make money for their shares to grow. Moser: Yeah, and, I mean, we always say don’t confuse value with price. And, I mean, I just hear it all the time. “Wow, that stock is $800. It’s expensive.” I mean, well, no, wait a minute, let’s take a look and measure the profitability of the company, the revenue of the company. And that’s why we have those metrics, whether it’s a multiple-based valuation approach on a price to sales or price to earnings. Maybe you’re looking at the cash flows the company produces. Mann: You need assets. Moser: Yeah, going back to the money — yeah, with banks and insurance companies particularly, assets — but there are fundamentals there in regard to the income statement, the cash flow statement, and the balance sheet they can give you a pretty clear picture as to whether that business is expensive or cheap. But we say it all the time, do not confuse value with price, because they’re two completely different things. Hill: Well, and the last thing is, you want to, when you’re starting out, find businesses that you can actually understand. To me, that’s always been one more knock against penny stocks is, a lot of times, you’ll get an email from someone, “What do you think about this?” And not only is it a penny stock, but it’s also some exotic business. Mann: It’s something that’s going to cure cancer. Moser: Some ad campaign. Hill: It’s some tech gizmo thing that’s going to change the world. And it’s like, really? What about a business I can actually understand, like a retailer? Mann: I didn’t realize goats needed to be brought onto the cloud, but there you go, I see how that’s a business point.  Moser: Sounds like an opportunity. Hill: Alright, we’re going to get to your watch list stocks in just a second. But first, since we were talking about fractional shares, what’s one or two sort of large company out there that you’re a fan of, that you think, on a relative basis, is not an expensive stock? And, once you start to put fractional shares to use, you are able to buy it — I mean, you mentioned Amazon. I immediately thought of Booking Holdings, the parent company of Priceline. I don’t want to say they’ve cornered the market of online travel, but they’re getting pretty close. That’s another stock that’s approaching $2,000 a share, if not higher. Moser: Yeah, certainly, Booking is one that comes to mind. One that I own. I love the travel space and their dominance in it. Another one that we talk about a lot here, and I’d imagine that most of us here at Fool HQ own it, is Markel Insurance. And we call it oftentimes our baby Berkshire because it is very much in that mold of Berkshire Hathaway. Leadership there has been running that business accordingly. And they have a great little competitive advantage in their specialty insurance business that allows them to really grow without having to cater to these arbitrary quarterly targets and whatnot. And I think those shares are somewhere around $1,150, $1,200 today. But in a valuation perspective, I think it’s around 1.5X book value, which is actually kind of attractive in today’s market particularly. So, one that I think we tout a lot, a lot of people are always interested in owning it, but it’s a little bit more expensive-looking. That could be one certainly worth getting on the radar. Mann: Yeah, Chipotle is another one. Trading at $850 a share. It has come all the way back from before the foodborne illness scandals that hit the company four years ago. Does that sound right? Let’s say four years ago. Absolutely incredibly well-run company. They have new management. The manager from Taco Bell came in and took over. And, yeah, $800 a share. When we first started talking about it at The Fool, it was in its $40s. So, that’s been a pretty fantastic run. Still, it has become a better and better run company. Moser: And if they add breakfast to the menu, man. Talk about your catalysts. Hill: Alright, let’s get to stocks that are legitimately lower than $20 a share, for anyone who’s looking to build out a watch list. Jason, what do you got? Moser: Yeah, so this is one, I actually highlighted this one on Motley Fool Money a little while back. And some folks out there may be familiar with Nuance Communications. Back in October, Nuance spun out a part of the business called Cerence, ticker CRNC. Cerence builds automotive cognitive assistance solutions. That’s a really fancy way of saying, when you get in your car and you need more information, or entertainment, or you’re looking for safety or convenience features, Cerence is using artificial intelligence and augmented reality technology to build out a lot of these solutions for cars out there, whether they’re cars that we’re driving or they’re self-driving cars. This is a really neat business. It is one that essentially just came to the public markets in October via the spin-off. So, for all intents and purposes, it is an IPO in that regard. So, it’s not one that I own. It’s one that I have on the watch list in our AR service here today. I really do think it’s a neat business. I like it. I’ve been paying very close attention to it. I think it’s around $20 a share today. It’s a small-cap company. $750 million market cap. There could be some attractive growth there. Mann: They spun out of the business from Nuance that was the reason to be excited about Nuance. Moser: Yeah, save maybe the healthcare side. But yeah, I think their automotive solutions business has just done so well. And it’s neat to see them on their own.  Hill: Bill Mann, what about you? Mann: See, I took this assignment very literally, and I found a company that is actually at this point trading at about $100 million. And the reason it’s trading at about $100 million — Hill: Wait. The market cap is $100 million. Mann: Wouldn’t that be great? Shares at $100 million. Yes, a market cap of $100 million. It’s actually a failing retailer called Stage Stores. Hill: A failing retailer? Go on! Moser: Tell me more? Mann: [laughs] That’s right. I know that doesn’t sound that exciting. It’s about 700 stores. The company is trading at about $3 a share right now. And they bought an off-brand retailer called Gordmans a few years ago, and immediately started to convert some of their other brands into Gordmans. And immediately had an enormous lift in sales. And they’ve decided to convert all of their stores, all 700 of them. It’s Goody’s, it’s a number of other brands that are going to get destroyed by Amazon if they don’t make the change. But they’ve made the change. The company is actually profitable. And you don’t really see really great things in the results right now because most of the business is the old stuff that they’re getting rid of as they convert over to Gordmans. But, it’s a company that I think is going to do great things in 2020. Hill: Alright, we’re going to get to your questions. As always, if you’re enjoying the video, please consider giving us a thumbs up. It helps other people find the video. And, again, check out our investing starter kit. Five stocks to get you up and running. Just go to fool.com/start, and we will email you our investing starter kit. It’s free, so give it a shot. Let’s get to the questions that are coming in. Steve asks, “What do you consider an absolute red flag when evaluating a stock?” I would say, we ticked off a couple of things earlier with penny stocks. I mean, anytime I see a price under $1 a share, that is automatically a red flag to me. Mann: For a U.S. company, yeah, absolutely. Moser: Yeah, I mean, I think I’d probably flip the question a little bit in evaluating a business, because I feel like the stock, I’m really focused on looking at the actual underlying business. And so, for me, if I look at the income statement and I see no revenue growth — or, even worse, declining revenue, and how that’s affecting margins, that to me, immediately, I’m trying to figure out what’s wrong with this business, and can it recover. Because a lot of times, it really can’t. Hill: Brianna asks: How can a new investor invest with less than $100? You mentioned some brokers that allow fractional shares. Is that enough to get started?” Mann: It is, yeah. In fact, I believe — I’m going to check and make sure I’ve got this right. M1 has, I think their minimums are actually $100. Stockpile is another. They have very low minimums. Robinhood is another. You can start with very little money. If you feel like that’s putting yourself at risk a little too much, put that money into a bank account and add some money to it. And when you get to $400 or $500, maybe then you can start to invest. But it is a golden age of investing. You can invest now with less money than you have ever been able to in the past. Hill: And by the way, that goes against the narrative that we certainly heard when we were growing up, whether it was overt or just sort of implied, the idea that it takes a lot of money to invest in the stock market; it takes a lot of time; it takes a lot of brain; Mann: It did! [laughs] Hill: — you shouldn’t do it yourself. And we have to mention it one more time. I think that the trading commissions going to zero is going to be one of those things that we look back on in 2019 and say, that was a turning point. Moser: There’s no question. I mean, I remember very vividly the days of forking over $50 to Edward Jones to buy X number of shares of stock. And even just to me, it felt like highway robbery. But here we go now. I mean, just interestingly enough, I was talking to Matty Argersinger the other day. Matty runs our real estate investing service here, Mogul. And you see the same thing happening in crowdsourcing real estate investments as well. We’re seeing a golden age on so many fronts for investors, whether it’s stocks or real estate. I mean, it’s just phenomenal, the opportunities that are out there. Mann: A little bit of it is technology, like what they’re doing at Mogul. I mean, let’s say a lot of is technology. And then some of it is just simply, as Jason said, they could get away with it for a year. So if you pay $50 in commission, that means, doing the math, you want to be investing a minimum of $10,000 on that transaction. Now you really can do it for $100. So, I encourage Brianna to get started. Hill: A few people are asking, “How can you tell a good small or micro-cap company from a penny stock?” It’s a great question. Because, I mean, the stock that you gave for the watch list, it’s trading at $3. Mann: It’s both, yeah.  Hill: On the surface, it has the earmarks of what we consider to be a penny stock, a stock you would want to avoid. But there are absolutely some good companies out there that just happen to be small at the moment. How do you tell the difference? Moser: Yeah, I mean, small-cap expert here, so I’ll defer to him. But, I mean, certainly, one thing, it’s not as apparent from the financial statements, but trying to understand the actual business, and if there is any kind of a competitive advantage there that will give them the ability to grow and either raise prices or have some switching costs involved. So, if you can find a business where there’s a discernible competitive advantage, that can really go a long way, Mann: Micro-cap stocks are a great place to look for companies, because most of the companies that are in the sector are terrible. Right? It’s just the case. They don’t want to be micro-cap stocks. A lot of them have been much larger in the past. It is expensive to be a publicly traded company. So, to be a sub $100 million company means something. So, you have to kind of figure out what that something is. For me, the way to find the ones that are better, the ones that you really want to pay attention to, if you think about companies that not only have a competitive advantage at that size, but that would cause some pain to their customers if they disappeared, right? It’s not just competitive advantage. It is, they have a moat. And there are several really small companies that do have them. Hill: Is it worth spending a minute talking about management? At the end of the day, it’s human beings who run these companies. And it seems like some of the red flags when it comes to penny stocks are, you start to just do a simple Google search on, well, who’s the person running this company? And you find out every member of his family is on the board of directors, or something like that. Mann: That tends to not be good. Hill: But on the flip side, some of these small micro-cap companies that really are just small because they’re starting out, and they’re on the pathway to becoming a small-cap, a mid-cap, a large cap, it often shows up in the management. Mann: I’d say even more so. I mean, if you look at a company like Google, which is impeccably run, but Google at this point, you could put a bot in the CEO’s desk, and I’m pretty sure it would do a reasonably good job. You can’t do that with a $100 million company. I mean, the $100 million company is really an embodiment of the manager. I’ll tell you one hint that I think about. I actually go and read the annual report, the letter from the management. And if it sounds like the man or woman who’s in charge has written it themselves, you can get a whole lot of insights about what’s important to them, how they’re managing, are they lashed to the mast of the business? Or is this something that they’re just trying to hype up and get out of? So, it is an area of the market that takes a lot of work. And these companies, as Jason said, aren’t ones that necessarily come to mind, but you can find some really, really great opportunities in the segment if you’re willing to turn over enough rocks. Moser: And we talk a lot about founder leaders. And while it’s great to find, that’s not always a guarantee. But I’ll tell you, founder leaders can really make a big difference. I look back to a company like Masimo that I’ve been covering since 2011. Pulse oximetry, right? I mean, this is healthcare, blood monitoring, founded by this guy named Joe Kiani. I mean, he built this thing in his garage. He just built it from nothing.  Mann: It’s his baby. Moser: It is his baby. He’s the CEO. And now he’s brought this thing to a $9 billion market cap, and there’s no sign of slowing down, either. So, when you can find that founder leader in and you can go back and you can hold them to what they tell you they want to do, that really can go a long way. Hill: Question from Daniel, who asks, “Investor friends told me this year, a recession is expected, and that stocks are currently overpriced. Is that true?” Mann: Yes. Moser: Yes. [laughs] Hill: What are the odds that Daniel’s friends may have said that in 2019, 2018, and possibly 2017 as well? Moser: Well, I’ve been here since 2010, OK, I think we’ve been saying it ever since then, right after the financial crisis ended. That’s one we could sit here deliberate all day until the end of time.  Mann: It’s going to happen. Moser: It’s going to happen at some point. The market feels overvalued from a number of different perspectives, but that doesn’t mean it can’t stop chugging along. We go back to that whole market timing issue. It’s very hard to do. That’s why we just espouse constantly, stay invested. There are sometimes where maybe it’s a little bit better time to hoard some cash, to save a little cash. But, yeah, there’s no clear-cut answer. Mann: And it’s not a satisfying answer. I’m not saying your answer was — Moser: No, no, I know exactly what you mean. Come on, Bill! Mann: You want to be able to say, looking out in the future, that these things really actually do mean that a recession is coming. I would suggest, as Jason did, that the market is probably somewhat overvalued, but it can be overvalued for a long time — and, by the way, we don’t have to buy the market, right? We are buying companies within the market. And they tend to move along with the market, but they aren’t defined by how the market moves. So, if you’re worried about a recession, yeah, put some cash on the side. You want to be able to sleep at night. But just know that there are people who’ve been sitting on the sidelines since 2012 sure a recession’s coming, and they’ve missed a lot. Hill: Sophie asks, “Bill’s recommended stock has debt and recently dropped from $9 a share to $3 a share. Can he explain a little bit more?” Mann: I took the assignment very seriously. Yeah, it’s a retailer — the debt load that they have is manageable. I don’t tend to, especially in certain industries, fear debt that much. What you fear is debt when a company has no ability to service it. Stage Stores has plenty of ability to service it. They just came out with earnings this last week. And the earnings were disappointing, but they were disappointing based on the department stores that the company is getting ready to get rid of. They’re getting ready to make a conversion to an entirely different strategy, and the strategy that they’re converting to, they know works. So, it’s painful, right? It was not a great quarter. But if you have a strategy that works, and you’re moving towards it, what is happening right now becomes a little bit less important. Moser: I’m glad he said that. Manageable debt, right? Listen, I’ve got like hundreds of thousands of dollars in debt, right? If you qualify my house payments. That’s OK. I mean, you can look at some of these companies’ financials and just remember, very quickly, just through their net interest income and their operating income, can they afford this debt that they have? The interest they’re paying on that expense line, and how much they’re making in operating earnings, you get a very clear picture of whether it’s manageable. A lot of times, companies are very wise about the debt that they use, and they use it to their advantage to grow the business. There are a lot of great businesses out there that have what might seem like big debt loads, but when you look at the financials, it’s a very manageable number. Hill: A couple people asking, “Can you explain the difference between price and the valuation metrics you look at to determine if a stock is cheap or expensive?” Moser: You have about an hour or two? Mann: [laughs] I’ll go get the whiteboard; I’ll be right back.  Moser: OK, so, in simplest terms, we’re looking at something from a multiples standpoint. I think price to earnings is probably the easiest one to look at. It’s going to differ depending on the company that you’re looking at. Retailers are not the same as tech companies. And they’re not the same as banks. And they’re not the same as insurance companies. And so, what we’ve always espoused here for our analysts and advisors is to have as many tools in the toolbox as you can in looking at valuation. So, whether you’re talking about cash flows or a multiple, it is going to vary. But typically, the lower those multiples are, the more perceived, at least, that a stock can be cheap. Now, you’ve got to understand what’s driving those multiples, but that’s the general idea. Hill: Ellen asks, “How do you guys think about index funds or ETFs versus stocks for beginners?” Mann: Love it. Hill: I was going to say, I think in general, we’re fans of index funds and ETFs. Mann: Plus, now, you can go fractional into a Vanguard or into an S&P 500 ETF. And the S&P 500 is the single best performing asset in the world over the last 10 years. Which doesn’t mean the next 10 years, it’s going to be the same. But people who have just said, “I’m going to start putting money into the S&P 500, do it in a very cheap way,” they have been rewarded absolutely spectacularly over the last decade. Hill: Question from Ross, who asks, “Are you guys worried about how the 2020 election will affect the markets?” Moser: I’m not worried about it. I think there’s bound to be an impact. But it’s not necessarily going to be the right one or the wrong one. I mean, you remember, the results came out in 2016. And that evening, or early in that morning, the market was tanking. And then when it opened, it was actually up considerably. So, it’s very difficult to determine how the market might react in the short run based on an election result that we can’t predict at this point. What I do know is that you don’t want that election result to keep you on the sidelines or prevent you from investing. Mann: Yeah. I think it’s pretty clear on the Democrat side of the fence that we are looking at, if one of the leading Democrats wins, that there will be a pretty massive push to change taxation policy in this country, and regulation, and things of that nature. But guess what? Things have changed, if not every four years, every eight years. And stocks have, generally speaking, not reacted in the way that people thought they were going to. Hill: I was going to say, one thing I’m positive of is that when there finally is a Democratic nominee, there’s going to be just scads of articles and interviews of people saying, “Well, if this person gets elected, invest in this, short that.” And to your point, that happens every four years, and it’s almost always wrong. Alright, Jason Moser, Bill Mann, guys, thanks so much for being here! Thank you so much for watching! Thanks for giving us a thumbs up to help other people like you find this video. Again, check out our free investing starter kit. Go to fool.com/start, five stocks to get you started. It’s free, so check it out. Thanks again for watching! I’m Chris Hill. We’ll see you next time.