Penny Stocks

OF late authoritative voices have been concerned about the market activity in penny stocks. Twice President Charles R. Gay, of the New York Stock Exchange, has warned the public against such purchases. ‘I cannot stress too much,’he said on the last occasion, ‘the plain fact that just because a stock is selling at a low price is no guarantee that it is cheap.’ James M. Landis, retiring chairman of the Securities and Exchange Commission, has reënforced the admonition. To no avail: low-priced stocks continue to feature stock trading, as they did in the last few weeks of 1936.

I am not sure that the general investing public can be blamed for this reputed addiction to low-priced stocks. Many sound stocks used to be penny stocks. In 1932, 90 per cent of the stocks listed on the Big Board were selling under $18. Even U. S. Steel, the bellwether of the entire American economy, touched a low of 21¼. Nevertheless it was in 1932-1933, when the heart seemed to have gone out of the economic system, that the stock books of U.S. Steel revealed the largest number of stockholders on record. Evidently the relatively penny situation of the stock had attracted the small investor. How well he has been justified, if he has held on to this purchase, was revealed the other day when Big Steel went soaring over par, still with its full prospects in the business recovery unrealized.

Just as there were many sound stocks which were low-priced a few years ago, so there tire sound stocks in the same category to-day, though of course they tire far fewer than the activity in low-priced stocks would seem to indicate. This makes a blanket indictment impossible. You simply cannot call all such issues ’cats and dogs.’ Consequently, there will always be investors attracted to the low-priced group, sound and unsound —ever hopeful that their selections will join the upward procession.

How, with the minimum of trouble, can one determine whether low-priced shares are really cheap? The task is difficult. For stocks represent dynamic situations; in other words, they cannot be truthfully pinned to a yardstick of statistics. Nevertheless I have put together a few factors which may be helpful as a starting point in approaching the investment problem relating to low-priced issues.

A purchase of stock makes you a partner in the underlying corporation. That might appear to be a commonplace. Unfortunately, both the unsophisticated and the sophisticated are oblivious of it.

Among the former, such obliviousness is due to the separation of ownership from management and the dispersion of stock ownership among the financially unlearned. Social reformers have written a good deal on this development. For it tends to divest stockholders of any feeling of industrial responsibility. At this stage of the cycle, indifference to the industrial ownership that one has purchased is likewise wrong, investment-wise. As Charles Tillman, in a recent brochure, says; ’If the partnership channel of thought could be maintained in a consideration of large corporations and public ownership, it would be far better for the investor generally.’ On the opposite side William Walker Claflin’s book. The Challenge of Investment, may be cited. ' in theory,’ says Mr. Claflin, the investor ’is an act ual owner,’ but‘as a matter of practical fact he is owner of a certificate the dollar value of which fluctuates according to the supply and demand for similar certificates.’ ’That is all very well for the market operator; but for the average investor I prefer an approach to investment to be based upon the significance of partnership. I mean that the investor, casting about for a purchase, should look first at the property value of his contemplated investment, and find out how much of it he would be able to buy with his money.

For this figure of property or asset value the investor must consult the corporation’s balance sheet. The figure for which he is looking is the stated value of the common stock. With the stated amount of preferred stock, it is called book value. In view of the fact that accounting practice is not yet standardized, the shrewd investor would make a few preliminary inquiries as to the history of this valuation of the corporation property. Some corporations are conservative in their appraisals of their assets, others liberal. To the ordinary investor such a quest is troublesome. And it is needless in view of the manner of the calculation that follows.

We will take the property value of two corporations, Warner Brothers Pictures and General Motors, at their face value, and break down the problem of the investor who wants to own $1000 of the property of one or the other. Of course the calculation could be made with any brace of stocks.

A $1000 chunk of property (approximately 50 shares) in

Which is cheaper? Some investors there are, believe it or not, who do not bother to make any such comparisons. They think of market price as the only datum of cheapness. ‘Many stock buyers,’ says Mr. Gay, ’seem never to have got over the idea that a stock is a bargain just because its price is low.’ To these folk Warner Brothers Pictures would be cheaper than General Motors. Other investors might stop in our comparison before completing it. If they go only as far as the cost to them of $1000 worth of property, they would still say that Warner Brothers was cheaper than General Motors; for $1000 worth of General Motors property costs $3420, while $1000 of Warner Brothers costs $847.

If they pursue the appraisal to the end, however, they enter the domain of earning power. By no means, as I said a few months ago, is earning power the final word on the worth of stocks. Particularly it would not apply at the beginning of a business upturn, when investment in, for instance, Big Steel is based solely upon faith. But at this advanced stage in the business upturn the wise investor must augment his faith and imagination with objective yardsticks, and there is none more reliable than earning power. Our illustration shows that an investor would have paid $3420 for the privilege of watching $1000 of General Motors property earn $157.50 and $847 for the less satisfactory privilege of watching $1000 of property in Warner Brothers earn only $4.20. Certainly General Motors is cheaper, in spite of the fact that it is much higher in market price.

It is unusual in the history of the stock market that at this upper stage of a rise so much activity should be shown in penny stocks. Every stock-market cycle, however, is peculiar unto itself. In the current bull market many special reasons have been given for the attraction of low-priced issues at this late period. The delay in rounding the bend; the fear of, or confidence in, inflation — these may be some of those special reasons. Then there is the factor of speculation, evident in this no less than in other stock-market cycles, though, if my correspondence is any criterion, some people are mistakenly of the opinion that speculation has been ruled out by government regulation of the stock exchanges.

One need go no further than the data of turnover in low-priced issues for circumstantial proof of speculation. In a number of weeks during the last three months the ten most actively traded in stocks have been of the penny variety. In one week a penny stock turned over a third of its entire capitalization. It is doubtful whether the general public is responsible for such trading. At least the Securities and Exchange Commission do not think so, and the ‘S’ men, sleuthing for the speculative malpractices now banned by law, apparently have never been busier. I heard of a case the other day where an investment service which happened innocently to recommend a stock under suspicion found an ‘S’ man on its doorstep within a few days.