Buy “Low-Density” … How to Take the Guesswork Out of Valuing Stocks
by Louis Basenese, Advisory Panelist
Wednesday, August 26, 2009: Issue #1076
I don’t care what investing legend you idolize and try to emulate – Buffett, Graham, Rogers, Lynch – they all share a common recommendation.
Always buy undervalued stocks and sell them when they’re overvalued. Or more commonly: “Buy low, sell high.” Of course, if you’ve invested for more than a week, you know this is easier said than done.
Undervalued (cheap) and overvalued (expensive) are such subjective measures when it comes to investing. Most times we end up guessing and most times we end up overpaying.
But today, let me show you one amazingly simple way to always buy stocks that are truly cheap…
Why America’s Most Successful Investors Buy “Low-Density” Stocks
All you have to do in order to invest like Warren Buffett, or any of America’s most successful investors – and rack up easy double-digit gains – is to buy what I call “low-density” stocks.
I define density like this: The value the market assigns to the cash that a company has in the bank.
- A high-density ratio: Means the market overvalues the cash.
- A low-density ratio: Means the market undervalues the cash.
The reason I focus on cash is straightforward: It’s the most tangible, liquid asset – and the easiest to value. After all, $1 is worth $1, so it’s easy to tell when you’re overpaying or getting a discount.
Let me use an example to make this concept crystal clear…
- Company XYZ trades for $1 per share and has $1 per share in cash (total cash divided by shares outstanding).
- To calculate the density ratio, we simply divide the price per share by the cash per share. In this case, the result is 1.
Here’s the thing, though: A one-to-one ratio is uncommon.
Most of the time, you’ll have to pay a premium for a company’s cash. Right now, for example, the density ratios for more than 480 companies in the S&P 500 are higher than 1, meaning you’ll pay more for these shares than they’re worth in cash.
But it’s even rarer to find a stock trading at a density ratio below 1.
Density Ratio Below 1 = Cheap Stock & Massive Gains
A density ratio below 1 means a stock could be worth $10 in cash, yet it trades for $7.50. Or it’s worth $1 and trades for 75 cents, etc.
And rest assured, whenever America’s best investors can buy $1 for 75 cents or less, they do. And you should, too. That’s because these discounts, understandably, don’t last for long.
Just take a look at Cynosure, Inc. (Nasdaq: CYNO). It traded at a density of roughly 0.70 for about a month this year. Once investors woke up to the bargain on offer, shares surged 138% higher.
There’s another low-density stock up for grabs at the moment, too…
Buy This “Low-Density” Stock Today
If you want to put my low-density strategy to work today, consider Trident Microsystems, Inc. (Nasdaq: TRID), which makes specialized semiconductors used in flat panel televisions.
- With zero debt, $2.87 per share in cash, and a market price of $1.90, it trades at a density ratio of 0.66.
- In other words, when you buy Trident, you’re buying $1 for 66 cents.
Incidentally, such a steep discount also makes Trident a prime takeover target. And with $2.21 billion in cash, Broadcom Corp. (Nasdaq: BRCM) could easily afford the $125 million market cap Trident.
But, even if Broadcom doesn’t pounce on the opportunity, history dictates that other investors will.
Based on its low-density ratio, Trident needs to rebound 51% to return to a density ratio of 1.
I recommend you capitalize on this truly cheap stock before it’s too late.
Good investing,
Louis Basenese
Any investment contains risk. Please see our disclaimer.
16 Responses to “Buy “Low-Density” … How to Take the Guesswork Out of Valuing Stocks”
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In addition to being the foremost expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
I and fellow investors have looked at TRID but although it is trading below cash and is a net net, the problem is that it has never been able to make money.
The company also competes in an industry with no competitive advantage which doesn’t make it a good investment at all.
However, the “low density” method is a good one.
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According to Zacks, TRID P/cash flow is 3.5 with negative earnings this year and -.84/share next year. Here is a company without a record of making a profit in its past or prospects for making one in the near future. Does not sound like a Buffett style stock to me.
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Its very interesting & eye opener for new investors.
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just one word. excellent!
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Is “Low-density” another way of saying Low price to cash flow? Why create another jargon when the same is already in place? Just to attract readers?
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TRID has been going down since about March 2006 (more than 3 years) and their latest FY (june 2009)is showing a 64 cents per share loss.
Doesn’t appear to be a stable company….But,
your announcement may have helped create a possible quick 20% if bought on open and sold same day as you anouncement.
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So, how do we find this cash value to determine the density ratio?
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High density, low density, isn’t this just a simple restatement (or redressing) of one of Benjamin Graham’s rules of investing? Buy a company’s cash for less than it’s worth.
Regards
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THIS IS A VERY USEFUL ARTICLE. IT GIVES ONE MORE DIMENTION IN LOOKING AT THE STOCKS, MORE OF SUCH GREAT ARTICLES. THANKS.
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a great article demonstrating one more way to help value stocks
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It’s hard to konw what the “Cash” position is at the time of a Stock purchase. A lot can happen to a company since the last financial statement.
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If all these newsletter writers have THE #1 SECRET to making millions on the stock market, then why do they still have to work for a living like all of us newsletter reading shmucks???
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Enjoyed the commentary on stock value density and i’am looking forward to more.
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Interesting approach. As others have pointed out for this specific stock, it’s important, when you find a stock with low “density,” that before you issue the buy order, you ask the key question, “WHY” is the stock valued the way it is? What are the fundamentals of the company? Do you understand how the management expects to USE the cash you are buying to generate a return for you, the prospective owner of the company?
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It’s great that Louis can create a “pump and dump” opportunity for the early birds, however…
The next 4 quarter outlook for this company is to burn through the “extra” cash. Given the outlook $1.90 looks about right. I feel sorry for the people that got in at $2.25 and will find themselves with a “high density” stock in the future…
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Every thing you suggest and advise is appreciated.However,how we indians can invest in foreign ( U.S.A ,Chinese,Hongkong ) companies.
pls advise
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