Cheap Stocks to Buy (That Aren’t Penny Stocks!)


Chris Hill: From Fool Global Headquarters,
I’m here with Ron Gross and Emily Flippen, senior analysts. We’re going to take your
questions in just a few minutes. Let’s talk about cheap stocks. Let’s name some
names here. Emily, I’m going to start with you. What’s the stock out there in the investing
world that you think looks cheap right now? Emily Flippen: I was clearly way too excited
about this one. I like this one. It’s trading at, last time I checked, high hundreds,
I think it’s $160. That’s Constellation Brands, ticker STZ. Constellation Brands isn’t really
a value play in a traditionalist mindset. It pays a dividend, so you get that for points
for value. But, it’s only about a 1.5% yield. When you look at the price, I think a lot
of people might think, “Wait, isn’t that expensive?” But it’s a company that not only is consistently
cash flow positive — it’s a cash cow — but this beer producer also has a $4 billion investment
in Canopy Growth, which is a great cannabis company, as well. And the stock price has
been depressed recently because that investment has not paid off for them, at least for the
time being, as Canopy Growth is increasingly unprofitable. But I think anybody who studies
the cannabis space knows how competitively positioned Canopy Growth is. So, Constellation
Brands is really value, in my opinion, in the sense that the company — we talk about
P/E ratios. It’s easy to forget that there’s growth that needs to be accounted for.
So, the PEG ratio, for instance, might be better, that’s the price to earnings over their earnings
over their earnings growth projected over a period of time. So, it accounts for the
fact that you associate some level of growth with these companies. With the growth that
Canopy associates with Constellation Brands, it’s actually one of the cheapest cannabis
companies out there. So, it’s a company that, when you look at the stock price, you might
think it looks really expensive. When you look at the P/E ratio, you might think it
looks really expensive. And when you look at the dividend yield, you might think it
looks really expensive. But in reality, it’s a really cheap stock simply
because of its growth opportunities. Ron Gross: I think that’s an important point
to mention. You’ll often see high-growth companies trading at high P/E ratio multiples, and for good reason,
because their earnings are growing so quickly. Hill: Ron, what about you?
What’s a stock out there that looks cheap to you?
Gross: I like Target, TGT. Last quarter was one of the best quarterly performances they’ve
had in years. I think these discount retailers are setting themselves up pretty well in a
retail environment that seems like it’s always somewhat shaky, especially if you’re a specialty
retailer. But Target’s done a nice job reacting to this Amazon-ian world we live in. Digital
sales were up 34% last quarter. Online sales now account for more than half of total same-store
sales. They’ve gotten it down to where they can deliver quickly. They’re playing
into that world very, very nicely. From a stock perspective, 17X earnings.
P/E ratio of 17X. Again, that’s vs. 18.5X for the market, so it’s selling at a discount
to the market. Perhaps more importantly, significant discount to similar types of companies.
Costco, 34X. Dollar General, 23X. Walmart, 23X. Again, this company is trading at 17X.
Now, you can’t just look at the numbers. You have to say to yourself, “Well, why?”
And there’s reasons why. Target has not had the best three to five-year period, I would say.
They’ve had to get their act together. But it appears they have. If you can get in
at 17X and ride this wave of ‘act together,’ I think you’ll have a nice investment.
Hill: Alright, we’re going to get to your questions in just one second. I want to get
a couple of more stocks for this reason. Again, it’s natural to anchor on the stock price.
Despite everything we’ve said and the fact that the overall market cap is really what
you want to be looking at, it’s perfectly natural for people to anchor on the stock
price. Constellation Brands, Target, wonderful businesses, stable businesses.
Constellation Brands, close to $200 a share. Target, somewhere in the neighborhood of $110 a share.
Let’s bring the price point down and see if we can find stocks under $50 a share, but also check
some of the boxes that you guys are talking about in terms of valuation.
What do you have, Emily? Flippen: A company that I’m really excited
about right now, David Gardner has also been really excited about, I think it’s a double
recommendation in Stock Advisor, is Zynga. Zynga is an out-of-favor game company.
Back when everybody was really excited to be on Facebook, they made Farmville.
That was peak Zynga. Gross: Oh, good old Farmville!
Flippen: [laughs] Yeah, exactly. Since then, the company’s faltered. But new management’s
come in, and they really have a strong pathway laid out for them in terms of gaming growth.
It’s trading around $6 a share right now, so it’s cheap in the sense that it’s under
$10 a share. But the actual company itself is pretty solid. They have a lot of really
impressive revenue growth. What’s really interesting about the business is that revenue growth
doesn’t actually capture how great the business is. You look at revenue growth, which, over
the last quarter, was 41%. That’s really impressive within itself. But, also look at what they’re
calling billings growth. A lot of the revenue comes from these in-app transactions.
They have games that you get on your mobile devices, and whenever you purchase something in-app,
let’s say in-game currency, they don’t account for that revenue right then.
It’s actually counted for over the useful life. So, they have billings, which is a better sense
of their actual projected revenue, which explains why their cash flow is actually consistently
more than their accounting net income. And that’s growing over 60%. So it’s a really
impressive business. Lots of growth opportunities, and it’s cheap in the
sense that it’s under $10 a share. Hill: Ron, what do you got for me?
Gross: I just get in right under the wire at $49 a share for Texas Roadhouse, TXRH.
Restaurants are notoriously a tough investment. But I think we found one here that’s put up
such solid results over the years that you can feel comfortable with it. They’re full-service,
casual dining restaurants. 590 locations in I think all states except one throughout the
country. Really great culture. Sound financial statements. 37 consecutive quarters of same-store
sales growth. So, each individual store measured year over year has grown their sales for 37
consecutive quarters. Really, really impressive! Interestingly, lots of folks, especially restaurants,
are seeing labor costs go up. That has actually taken a bite out of profits. As a result,
we’ve seen the stock price be a little shaky recently. In fact, in a very strong market,
Texas Roadhouse is down about 17% this year. That’s something interesting about so-called
cheap stocks. Sometimes there can be a shock to the system, which hopefully is a temporary
shock to the system, to bring down a stock price to make it more undervalued than perhaps
it was before something bad happened. I think that’s what the case is here. The company’s
buying back stock. When a company’s at a depressed stock price, I like to see that use. 2.2%
dividend yield, so returning capital to shareholders. I like that as well. From a stock perspective,
I’ll give you another metric, enterprise value to EBITDA — EBITDA being a simplistic measure
of cash flow. Only 13X EBITDA. That’s vs. the median of comparable restaurants that
I compare it to of 18X. 13X vs. 18X to me indicates a relatively inexpensive restaurant.
Hill: From a business standpoint, here’s what I like about Texas Roadhouse:
they don’t serve dessert. They’re basically like, “Hey, we want you to come in, have a good meal,
then we want you to leave so we can turn over the table and get those tickets moving.” 
Alright, keep the questions coming. And hey, if you like the video, please give us a thumbs
up. We always appreciate that. It helps other people find the video. 
Let’s go with this first. Walter asks, “What’s a better measurement, price to earnings or
price to EBITDA? Are there stocks where other valuation metrics make more sense?”
Gross: I’ll answer this question without getting too much in the weeds. Earnings are a fine
measure of how a company is doing, but not a great one. That’s because there are certain
accounting rules, generally accepted accounting principles, GAAP, that companies must follow,
that tend to make actual results of a company a little bit murky. A lot of those things
that make it murky are non-cash charges. EBITDA attempts to adjust for non-cash charges,
the biggest ones being depreciation and amortization. To give you an idea, if you owned 100% of
that business, how much cash could you literally put in your pocket at the end of a year?
So, for me, that is a better measure. Flippen: I think it depends on which
company you’re looking at. Price to earnings, it’s easy enough to calculate. You have the market
cap of the company divided by probably the trailing last 12 months’ worth of earnings,
or you can use a forward PE, projected earnings for the next year. But for me, what’s more
indicative is actually price to sales. I know that’s a little bit counterintuitive,
because the idea of investing is, you get earnings. If you’re buying shares of a company,
you want that to flow back to you as a shareholder. But I think the world that we’re living in
today values a lot more based off presence and sales, and not a lot of companies have
accounting earnings. They can be producing a lot of cash, but they don’t have an E.
And if there are no earnings, you cannot calculate a price to earnings ratio. So what I do is,
I look at the price to sales as the market cap divided by their sales, and then I compare
that to what I think their total addressable market is. That’s where it gets tricky,
because what defines a total addressable market, the TAM, is different depending on analyst to
analyst. So that’s where the subjective part comes into analyzing stocks. That’s what
makes this job so exciting, is determining, what is that market opportunity? And then
finding out what portion of that market can they achieve? And in the cases of companies
like Uber, are they in an entirely new market? You can’t really look at the cab market and say
that’s indicative of Uber’s total addressable market. So, it’s an interesting conundrum, but I would not
say price to earnings alone achieves that. Gross: And will you
agree with me that eventually, sales have to one day translate to earnings
or cash flow, or the company theoretically is worthless? A company has to produce cash
flow at some point, or it’s worth zero? Flippen: I think there’s two levels to that.
Yes, long-term. They need to have some sort of viable business that is sustainable.
We’ll see a lot of companies over the short term raising funding, and as long as it doesn’t
dilute shareholders in that meantime, and as long as they’re able to continue to raise
funding — Tesla being a great example — that can still be a good value for shareholders.
Hill: Question from Cindy, who asks, “I’m a new investor, can you do a quick
walkthrough on finding and calculating the P/E ratio?” Gross: My esteemed
colleague just did! Do it again! Flippen: [laughs] Easy enough! So, if you’re
interested in a company, something as simple as, let’s say, Stitch Fix, you can look it
up, Stitch Fix stock. Find the market cap. It’s right there, Google will tell you.
Then, go to their financial filings. This is usually reported in their 10-K, which is the most
recent quarterly report. You can find their last 12 months’ worth of earnings.
Simply divide the market cap by the earnings. That’s the P/E ratio. A lot of free sites will
calculate for you. If you go on Yahoo Finance, they tend to have a rough
calculation of P/E there as well. Gross: And you can do it on a per-share basis
too, just take the stock price divided by the earnings per share,
and that’ll get you the exact same number. Hill: Speaking of 10-K’s, Justin asks,
“When it comes to 10-Ks, what is important to look at and what can I ignore?”
Gross: Oh, Justin! [laughs] I think the average investor can largely ignore the footnotes
of the 10-K where nerds like me really like to dig in. But I think for the most part —
Hill: It’s the annual report. Gross: It’s the annual report. I don’t think
the footnotes are essential to the average investor. I think understanding the business,
which is probably the first five to 10 pages, is the most important thing an investor can do.
Understand what a business does and how they actually make money, or how they will
one day make money, is the most important thing to do. And then, as far as financial
statements, to me, the cash flow statement is the most important statement.
Flippen: I would definitely say, for me, the first thing I do when I look at the financial
statements themselves, when I look at the numbers, I go towards cash flow. Cash is really
king in this industry. In a worst case scenario, where they’re accounting profitable but losing
money in their operating cash flow, that to me is a huge red flag. You’ll see it a lot
with companies, actually, because they can manipulate their earnings, but they can’t
really manipulate that operating cash flow. So, that’s something I look for in a 10-K. 
I will say this. Warren Buffett, I think, notoriously reads 10-Ks the opposite way that
you do, Ron. He goes from the footnotes all the way to the top. 
Gross: As do I too, but I don’t think the average investor needs to.
Flippen: Yeah, the average person probably doesn’t need to get that sort of level. But it’s
important to understand how they make money. You might think that you have an understanding
of a company like Zynga. Right? But you still might not understand that a lot of their revenue
is deferred revenue associated with billings, and that’s how they make a lot of money. So, understand
how that money is being made before you invest. Hill: A few different people are asking, “Is it worth buying one share of a company
like Amazon or Booking Holdings,” formerly Priceline, now Booking Holdings. Great question!
We were talking before about stocks that cost $100 or $200. These are stocks that cost somewhere
in the neighborhood of $2,000. Is it worth doing that? Gross: The short answer
is yes; it is worth doing. Again, it doesn’t matter the number
of shares you’re getting, it matters how much capital you’re investing in the business.
Now, in a world where you have to worry about commissions, you should be a little bit careful.
You don’t want to buy such a little amount of a stock that your commissions are more
than, let’s say, 2%. If your commissions equate to 5% to 7%, that stock has to get up to 5%
to 7% just for you to break even. So, we want you to be careful about the commissions you’re
paying. Fortunate for investors, commissions don’t seem to be much of a problem anymore!
Commission have largely come down to zero, and even before that, they were as low as
$4.95 per share, so not egregious at all. It’s a new world, and we’re able to buy many,
many of our favorite stocks commission-free now. And putting $2,000 or $1,000 into one
share of stock, perfectly fine. Hill: Question from Uncle Greg, who asks,
“I know stock splits generally don’t matter but what about a reverse split? I’m thinking
about Rite Aid here.” Let’s focus on stock splits for just a second. I understand we
had some audio trouble before. Real quick, let’s just go over stock splits again,
and then we’ll get into reverse stock splits. They’re both events. They’re both noteworthy.
But, I would argue, for different reasons. Gross: Stock splits are when a company simply
decides to break the company itself into more pieces, typically twice more, but it can be
anything they want. When a company goes through a two-for-one stock split, all of a sudden,
there are twice as many pieces of the pie outstanding, which cuts the stock price in
half. That has changed nothing about the entire company overall. The entire company’s market
capitalization is exactly the same as it was pre-split. Companies will sometimes do that
if a stock has gotten really high and they want to lower it because they think investors
will be more attracted to that company if it’s at a lower price. Famously, Warren Buffett
has never split his A shares, and they’re selling for hundreds of thousands of dollars,
because he’s not worried about that. But stock splits really are more window dressing
than they are doing anything to actually change the company.  Now, reverse splits,
on the other hand, folks usually do that because they’re in trouble.
Usually, if you drop below $1 a share and you want to stay listed on a national exchange,
you need to do a reverse stock split. You take away half the number of shares,
which automatically doubles the share price and allows you to stay listed on
an exchange. Be careful of those. Flippen: I’ll just add, in particular to
Rite Aid, it’s easy when you’re looking for cheap stocks or value stocks, like I said
before, to go for stocks that have fallen significantly, because they look cheap on
the market. You think, it’s down 30%, so it’s 30% cheaper than it was maybe a month ago.
In reality, if a stock’s falling that much, they probably have underlying business issues.
So it’s important when you’re looking for a cheap stock that you’re not buying a cheap
company. If you’re buying a cheap company — in my opinion, Rite Aid is a great example
of a company that’s just been on a slow decline for a long time, decreasing revenue — you’re
not going to find a good deal on a company that’s bad. Oftentimes, great companies come
with high price points. That’s the reality of the world in which we live. That doesn’t
make them bad investments. But I guarantee you, just because Rite Aid’s down 30% doesn’t
mean that it’s overdue for a correction. Hill: Robert asks, “Are tobacco stocks dead?
It seems like there’s a lot working against them.” Certainly, if you think about all the
news that’s come out regarding vaping and the illnesses that have cropped up because
of vaping. Vaping was one of those things, e-cigarettes seemed like it was a market opportunity
for tobacco companies. If that’s not completely off the table, certainly the
pause button has been hit on that. Flippen: That’s such a nice way to put that.
“The pause button has been hit on that.” I think, as of today, we’re now up to two dozen
deaths associated with vaping-related illnesses, and the FDA sitting over here thinking,
“We have no idea what’s causing it.” It was actually a smart move on behalf of tobacco companies.
We don’t do a lot of tobacco investing here. It goes back to investing in companies that
are growing, not declining. But tobacco saw the writing on the wall. For example, Altria,
making that investment in Juul, the easiest one to pull on. That investment, at the time,
actually seemed like a really great idea. I think, associated with these illnesses, now that
investment’s looking like it’s increasingly negative. But, I don’t think that inherently
means that any company that has vape exposure — that includes a lot of cannabis companies
— are doomed. I think we need research. We need time. And I think ultimately, other ways
of consuming nicotine and THC are going to be important for ensuring consumer health,
while still making their products available. But, yeah, big tobacco has been a conundrum
for a while because they know that their business is declining. They know that it’s challenging
for them, and they’re scrambling. They’re scrambling to figure out a way to make their
businesses grow. It’s really not working for Altria right now.
Hill: Walter asks, “When a stock splits, how does that affect the dividend?”
Gross: Let’s say you have twice as many shares, and the dividend gets cut in half, but you
still have the exact same amount of money. So, literally nothing changes.
Flippen: Quick math. [laughs] Gross: [laughs] I don’t like to do math on
the fly. But I could say for sure that nothing changes in terms of
the dollars that you’re getting. Hill: I always think of it in terms of pizza.
Pizza is the same size. Do you want it cut in four slices or eight slices?
Flippen: Yeah, that’s why you look at dividend yield, not dividend number. A $0.10 dividend
is totally different than a $1 dividend. You can’t say one is inherently better than the
other. You look at the yield, which is that dividend as a portion of the stock price,
and the stock price does change when you split. Hill: A few people asking, “What happens
if a cheap stock suddenly is no longer cheap? Does that become a reason to sell?”
Gross: Could be. To me, if I don’t think a stock will generate the rates of return
that I need it to do in the future — again, hopefully beating the market, which is around
a 9% or 10% return — if a company can’t generate for me a 9% or a 10% return going forward,
then there’s really no compelling reason to keep owning it. I could just buy an index
fund or perhaps put my capital to a different stock that will generate the return that
I’m looking for. So, at a certain price, my calculations tell me, this is not going to do it for me,
it’s not going to get the job done for me, and I would sell and move on
to a different investment. Hill: Emily, would you like to offer a rebuttal?
Flippen: I think when you look at cheap companies, the idea of buying a cheap company is recognizing
something that the market doesn’t recognize. Just because the market starts recognizing it doesn’t
mean that that company is a bad investment. In fact, if you’re investing in
a good company, waiting for that company to be recognized by the market as a good company,
then selling it, then you’re probably giving up a lot of opportunities in the future.
I think any successful individual investor knows that their best performers are companies that
they’ve just held for five, 10, 15 years, through all the noise. Every good company
at some point or another has looked horribly overvalued. You’re probably giving up a lot
of gains if you’re selling something just because it’s no longer cheap.
Hill: Amy asks, “Are we done with all the massive share buybacks? How has that affected
the market?” Great question, in part because, let’s face it, there are some businesses out
there, stable businesses, that their strategy for rewarding shareholders is a steady diet
of share buybacks. I’m thinking of AutoZone, just to name one.
Gross: I don’t think we’re done. Companies are still flush with cash. Stock prices are,
what are we on, an 11-year bull market? You have to be careful about using capital to
buy stocks that may be overvalued. I think companies are notorious for doing that. Often,
buying back your own stock is a poor use of capital. We like to see CEOs that are strong
capital allocators, not weak. But I think for sure, we’ll see buybacks. I’m seeing reauthorizations
of share buyback programs all the time, every quarter. It doesn’t seem to be
waning to any significant degree. Flippen: I think there’s two levels of share
buybacks. The first being, if a company’s buying back shares, it means that they think
they can get a rate of return on that investment, buying back their own shares, more than what
they can investing that money somewhere else in their business. So in some respects,
that’s concerning to you as an investor. If you’re going to take a million or a billion dollars
and buy back shares, what else could you be doing with that? And if you really can’t find
a better value, is that great because I own shares, and that’s a really good value? Or,
is it because you’re floundering, and you don’t know what to do with your money?
The flip side of that is, companies do like to reward shareholders, and that’s the more
tax advantageous way to do that, as opposed to issuing a dividend, is buying back shares. 
So, it’s two levels. I don’t think it’s inherently great or bad. I would just ask myself the
question of, what opportunities are they giving up by spending this money on share buybacks?
Hill: We got a question from John asking, “When is a stock buyback a good decision?
When is it a bad decision?” A lot of times, Ron — and this may not be a satisfactory
answer, but I think it is the truth — it comes down to track record. You can see certain
companies and certain management teams, you look at them over maybe a three to five-year
period, you know if they’ve done a good job of being advantageous in terms of their buybacks.
Gross: Yeah. You can look at track records. CEOs have a decision to make. There’s a certain
amount of cash, and there’s a business to run. They get together and they say, “If we
invest in that, that, and that, we think we’ll earn an X rate of return. But if we invest
in our own stock, we think we’ll either do better or worse.” If the answer is worse,
I would hopefully not want to see them execute on that buyback. But if they can,
as Emily said, think they can earn a return better than some other investment out there — and
they know more about the company than anyone — then theoretically,
that should be a good use of capital. Flippen: And let’s make this decision even
more complicated. Companies have been known to issue debt to buy back their own shares.
So, there’s a question of, yes, debt should be cheaper than equity, but is that within
itself a decision that is rewarding to common shareholders like us?
Hill: Carol asks, “Emily is on the screen, what’s a good cannabis stock to buy?”
Flippen: [laughs] Well, I already gave you Constellation Brands, which is a great
cannabis stock. There are lots of cannabis stocks that are really cheap in terms of being less than
a dollar, which I’m not sure are great investments right now. These are companies that I don’t
think you can buy one of and have really great exposure to the marijuana industry,
which is why the work that I do is manage a portfolio, because the only way
to do it is by taking a basket approach. But one company that I think is both a cannabis
company and cheap, although it’s not going to be a satisfactory answer for a lot of people, is actually
Square. Square is a really innovative company. They recently announced last week
that they’re launching a pilot program for CBD payment processing. That might not sound
very exciting, but it’s a huge opportunity to the U.S., because we’ve been extremely
restrictive for financing and payment processing for cannabis companies, which makes the value
that Square is providing that much more valuable. The ticker is SQ. It’s a great company.
I think it’s a really undervalued company. It’s a cheap company. I think it trades around
$63 right now, so it’s not too unaffordable, and it has a lot of growth
opportunities ahead of it. Hill: Ron, Emily talking about how a lot
of cannabis stocks out there are trading for a dollar. It makes me want to go back to penny
stocks just for this reason — if you take nothing else from this video, can we just
hopefully implore people to avoid penny stocks like the plague?
Gross: I think penny stocks are a proxy for risk, very significant risk that will, I think,
on average, burn you rather than benefit you. So, yes, I would agree to stay away.
Hill: One more question before we wrap up. “I see a lot of price to sales based valuations
with newly public companies. Is this legit or window dressing?” Well, certainly,
some of the newly public companies that we’ve seen this year seem to be engaging in a bit more window
dressing than actually executing on their business. Gross: And price to sales is out of necessity because there’s no earnings and there’s no
cash flow, so you have to have some metric. Emily’s not afraid to invest in price to sales
companies. I’m a little bit more shy about that kind of stuff. I prefer earnings.
I’m not that great at looking out into the future too far. A bird in the hand is one of my favorite things.
But, definitely two different types of investments. Flippen: To round it out, there’s a good way to invest in price to sales, which is looking
at the price of sales today, looking at the industry average price of sales — now,
this is confusing. How do you find an industry average price to sales? Aswath Damodaran,
professor at NYU, has a free public website if you just google “prices sales Aswath Damodaran,”
he breaks it down by industry, all these different ratios, the average for that industry.
So, what I like to do is, I like to look at the market cap today. Let’s say it’s a $10 billion company.
This is where the subjective comes in — let’s say the total size of the market
is a $100 billion market. They’re growing revenue at 30%. Let’s project out in the future.
If they’re able to grow revenue at a 20% CAGR for the next five years, what’s their sales?
What’s their new price to sales based off the industry average? Then you find that expected
market cap five years from now. That’s getting into the weeds a little bit. But the point is,
there’s a good way to use prices sales, and there’s a bad way to use price to sales.
You can’t look at a 60X price to sales and be like, “That’s horribly overvalued,” if they’re
growing in a way that justifies that valuation. Gross: Price to sales is a relative measure of valuation, just the way the P/E ratio is.
So, just that one number doesn’t tell you enough. Hill: Alright, check out our free investing starter kit. It comes with five stocks.
You can find it at fool.com/start. Also, please, if you wouldn’t mind giving us a thumbs up,
it helps other people find the video. And, subscribe. It’s free to subscribe to our channel.
We’re going to be doing these live Q&As every week, and we’d love it if you could join us.
Emily Flippen, Ron Gross, thanks for being here! Gross: Thank you, Chris!
Flippen: Thanks for having us! Hill: Thanks so much
for joining us and Fool on!

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