In Praise of Stocks Under $5

 | Jan 11, 2012 | 2:00 PM EST
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The Holy Grail of any competition is finding an edge against your opponent. Alabama's 21-0 defeat of LSU in college football's national championship Monday was a brilliant display of one coaching staff outmaneuvering another for 60 minutes. No doubt, Alabama coach Nick Saban and his staff spent countless hours studying, analyzing and developing the best strategies to beat their opponent.

Investing is no different, and may be the most competitive field outside of organized sports. Instead of competing against 32 football teams or a hundred golfers, an investor is up against countless investors who collectively make up the market. The reality is that there are very few ways for any single investor to outsmart this collective market.

So it only makes sense that the fewer competitors one has, the greater the chances of success. With the vast majority of investment capital controlled by institutions, mutual funds and hedge funds, investors are better served not trying to compete with that huge pool of capital. An alternative is to play in the pond and leave the ocean to the big fish.

One way to do this is by focusing on stocks that trade below $5 per share. The $5 threshold is not arbitrary; most investment funds are not allowed to trade in stocks priced below $5 because the industry views these companies as too risky. Regardless of merit or valuation, if shares trade below $5, they are shunned by the majority of professional investors. That leaves a field inhabited by fewer players, which makes price inefficiency a greater possibility and magnifies opportunities to gain an edge over the competition.

That's why shares in Premier Exhibitions (PRXI) can trade for $2.34 today, even though shares are probably going to be worth more than $4 later this year. This debt-free company with a market cap of $110 million is set to auction off its RMS Titanic artifacts in April, a collection that has been conservatively appraised at $189 million. It's only because individual investors and small private accounts are looking here that this opportunity is one of the most compelling.

It's also why insurance company Universal Insurance Holdings (UVE) trades for $3.52, or 90% of book value, and yields more than 9%. Despite gyrations in the insurance industry, Universal continues to distribute cash back to shareholders while operations continue to perform nicely.

Each year, the U.S. gets closer to a stable recovery in the housing market, and that is good news for Mueller Water Products (MWA), one of the nation's leading providers of water infrastructure products. Over the past few years, Mueller has worked hard to clean itself up by charging off goodwill and reducing its cost structure. Yet shares still sit at $2.70 or a market cap of $430 million. With a number one or number two market share in virtually every product line it sells, Mueller's not going away. It's simply a matter of when this company gets going again. This year could be that year.

For investors seeking a micro-cap gem, USA Technologies (USAT) could be just that. After climbing to as high as $4 per share last year, shares have fallen back to $1.18. One of the major reasons for the decline was the dismissal of the CEO after he was caught posting comments about the company in online investing forums. But the core of business has not changed. USAT is a leading provider of cashless payment systems. The company's products allow vending machines, DVD kiosks and other quick-pay machines to accept debit and credit cards. Next time you buy a Coke or rent a DVD, check the small black-box credit card swipe machine; it could be from USAT.

Odds are if the above businesses could be accumulated by larger investment funds, they would be. But because of an arbitrary share price restriction and market caps that don't render them feasible for larger funds, they often go unnoticed. The result is a great likelihood that an inefficient market exists for individual investors and other small accounts to exploit.

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