How to Not Get Burned by Low-Priced Stocks

TheStreet.com

NEW YORK (TheStreet) -- You can burn cash in all sorts of ways. Take up a hobby. Develop a habit. Rescue too many pets. Have too many kids. While you cannot put the one that snuck past the defense up for sale in the rotten kid auction, you can avoid losing money in the stock market.

The blame we like to direct toward "fat cat bankers" and rich CEOs notwithstanding, you can protect yourself from losses with hard work and, maybe more importantly, common sense. It also doesn't hurt to use readily available tools.

For instance, you buy 100 shares of a $15 stock. You tell your spouse you just risked $1,500. Not so: Risk equals the difference between your cost basis and your stop loss. One size does not fit all, but to avoid catastrophic losses, be ready and willing to take a series of small losses when things do not go your way. That's not rocket science.

Losing money comes with the territory in trading and investing. The winners just do a better job of managing (or they actually manage!) their capital.

As we learned the hard way with the Facebook FB IPO, use public information. Never buy a stock without scouring its public filings, particularly a couple years' worth of quarterly and annual reports. Had more people read through Facebook's S-1 filings, we might not hear so much whimpering and moaning.

Do unconventional due diligence
If I have learned anything during my time in the media, it's that it generally pays to do the opposite -- or simply not do -- what talk radio show callers and message board commenters say you should do.

Consider Sirius XM SIRI .

It might as well be a sports team. Not only is almost every message board comment made by a Sirius XM bull emotionally driven, but many come from people with vanity plates for screen names. SiriusBrit. Siriusman. Sirifiar. SIRI Dog Millionaire. siriusenough2012. serious business. Siriusly Undervalued. And my personal favorite, Sirius Love.

I did not make any of those names up.

While it might seem like I am merely poking fun, you really do need to pay attention to the phenomenon of at least some segment of a shareholder base resembling maniacal sports fans.

Would you take a stock tip from a drunk and shirtless fat dude, face painted, sitting in the bleachers at Cleveland Stadium with a rawhide bone hanging from his mouth in below-zero weather on the shores of Lake Erie? Of course not. It only follows, then, that you would not take Sirius Love's advice to "buy on the dips" in a comment populated by the signature line: "Long live SIRI."

All too often, low-priced stocks have a hope and a prayer attached to them. That's clearly the case with SIRI, a stock that ran from pennies to the $2-plus level. Just as we like the looks of owning 5,000 shares of a $2 stock over 100 shares of a $100 stock, we get taken by the math. If the $2 stock gets to $3, I am sitting on a cool $5,000 profit. If it gets to $20 or $50 or $100, I'm rich. We've all run those numbers in our heads.

Because this type of lotto ticket dream holds such allure, we seek out information that validates it as a real-life possibility. That's just basic psychology. We filter out "noise" that attempts to take the dream away.

We allow our investment to turn into a passionate battle of us against them. It happens more frequently with low-priced stocks because investors often associate the low price with the notion that the true value of the security has yet to be realized.

More often than not, the most vocal longs label market makers, hedge funds, bloggers, financial writers and others as "manipulators" colluding to "keep SIRI down." Passion breeds more passion. Emotionally charged attempts at logic beget a series of bad decisions. And before you know it, the dream dies.

Along similar lines, take great care when investing along the lines of taste, preference or sociopolitical leaning.

Just as most Sirius XM longs stand by satellite radio, plenty of folks believe electric vehicles are the logical and politically righteous future. They may or may not be. The answer to that question, even if it's "yes they are," does not necessarily mean every EV-related stock is a sound investment.

Consider Ecotality ECTY .

The company's CEO, Jonathan Read, is not quite on par with a Sirius XM bull, but you still must beware. While I appreciate his pluck -- and he clearly knows his stuff -- he sent me a red flag in January.

After I had written something only slightly bearish about his company, he fired an email off to me. He took a shot at a competitor and referred to himself as "the most candid and outspoken CEO in the industry." But he did not stop there. In a subsequent email, Read continued:
Buffett made a fortune on beaten-down and poorly understood stocks. We are both at this point, but as EVs roll out over the next 24 months our value propositions will become clear and be validated.

Read still has about 18 months for his prediction to come true, but since his email on Jan. 24, ECTY has plummeted 51%, from $1.12 per share to 55 cents. If things do not improve drastically between now and November, Nasdaq could delist the stock.

I have been approached by and have approached quite a few company founders, CEOs and other high-level executives. From time to time, these interactions make me incredibly bullish. On occasion, however, they turn me off. If you need to compare your stock to a Buffett pick and defend it like a Browns fan calling into a sports talk program on Monday morning, I'm concerned.

But, even more so, as I noted last month, Don't Buy Sectors; Focus on Business Models, Target Markets.

You might love satellite radio. You have a lifetime subscription. Read knows his industry inside and out. Like any good CEO, he's a confident chap. It's all good; but stock prices get depressed for the same reasons as people. Underlying lying reasons almost always exist.

Underlying reasons explain why Tesla Motors TSLA performs relatively well. And it's not because the company produces electric vehicles. Instead, it's because Elon Musk is a brilliant visionary. He and his team have done and will continue to do an excellent job serving a niche market of affluent types who will plunk down fifty grand for a Model S just like they did 110 grand for a Roadster.

If somebody, from chronic commenter to company CEO, tells you they have a "cheap" low-priced stock all because of misinformation, misunderstanding or manipulation, hop in your EV, crank up E Street Radio and drive away as fast as you possibly can.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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