When I started in this business way back in the 1990s, a stock split was the "sure" sign of gains to come. Tech stocks were starting their decade-long run and growing rapidly, and their prices were on the rise. It was a badge of honor to split your stock: It meant the company had done well so far, and signaled it was likely to continue to grow rapidly. Despite the protestations of efficient market theorists, stocks often jumped on the announcement of a split, even though they should not -- in theory. The market believed in the signaling value of a split.
A funny thing happened after the bubble burst in 2000 to 2003. With many hot tech stocks down 90% or more, and now languishing in penny-stock land, splits went out of favor. Aside from the risk of setting up the stock for penny status if things went wrong, management teams were noticing that Berkshire Hathaway (BRK.A) and a few other extremely high-priced stocks were the only ones commanding respect -- and a respectable price.
Suddenly everyone wanted to "Be Like Buffett" and not split their stock as a sign of financial strength. Some of the best growth names sport triple-digit stock prices, or higher. These include Apple (AAPL), currently at $604; Google (GOOG), at $610; Priceline (PCLN), at $673; Intuitive Surgical (ISRG), at $498; MasterCard (MA), at $423; and AutoZone (AZO), at $378. Having a multi-hundred-dollar stock price is the new badge of honor.
(The strategy of avoiding the split worked well for Netflix (NFLX). If the company had done a 30-for-1 at the peak price of $300, in order to get it back to a "buyable" $10, it would have been a $2.70 stock right now -- rather than a "respectable" $81.)
Seeing so many "hot" names with triple-digit prices got me wondering whether a high stock price was a signal of strong growth to come. Certainly the price got to its high level because of past growth. But was the badge of honor of a high price only retrospective, or was it prospective as well? I decided to study the matter, fully expecting to find that high prices signal future outperformance.
As is often the case -- and this proves why you should put data behind your assumptions -- the conclusion turned out to be the complete opposite. I looked at the next 12 months of stock performance of all the U.S. stocks, stopping at the small-cap level (defined as market capitalization greater than $500 million at that time). I divided the universe, which usually consisted of around 2,000 to 3,000 stocks each year, into decile groups based on price. In other words, the first decile group is the top 10% in the list, as sorted by price, whereas the tenth decile group is in the bottom 10% of the list.
As a group, high stock price was not a good indicator of anything other than poor performance ahead. Meanwhile, the lowest stock-price group consistently provided the best returns.
Study the table below!
In nearly every year of the past decade, a portfolio consisting of an equal-weighted holding of all the stocks in the lowest-price decile was the top-performing group, and outperformed the overall universe 83% of the time. Buying the highest price group is a losing strategy -- that group was never the best performer, and outperformed the universe only 8% of the time.
This conclusion makes intuitive sense. It's not because low-priced stocks have more "room to run" -- that is a fallacy, because percent changes do not care about the base. The intuitive appeal is that low-priced stocks are often under business duress, but reversion to the mean tells you many will turn their fortunes around and achieve outsized gains.
As a Real Money reader, you should already know that the group dynamic does not necessarily apply to every stock: Some high-priced stocks will do fantastically, and many low-priced stocks will languish. But remember -- in order to catch fish, you need to go where they are biting. This study indicates that the low-priced corner of the lake is one in which they are biting on a very regular basis.