Two great stocks for about $2

In this article we’ll discuss two stocks that we think have great future prospects. We’ll reveal their names later but, for now, will refer to them simply as stock A and stock B.

Stock A owns airports. We think the economics of its investments are very attractive and that it has excellent long-term growth potential. We’ve long recommended this stock and have twice upgraded it to our second-highest recommendation, once in issue 116/Nov 02 (Buy—$0.87) and again in issue 127/May 03 (Buy—$1.17). It was a Long Term Buy for a couple of months between those two recommendations. The group has a lot of debt, which makes estimating its true value somewhat difficult, but we think its value is greater than $2.50 and, depending upon what happens in the aviation industry over the next few years, perhaps more than $3. That stacks up nicely compared to its current stock price of $2.06.

Stock B is a leading construction and contract mining company. It has a very long history of profitability and stable management, and it possesses a huge order book. It’s currently trading at $1.79 and we’ve been strongly recommending it of late. In fact we upgraded it to an outright buy in issue 151/May 04 (Buy—$7.83). We feel the stock’s true value is closer to $2.40 than the current price.

So there they are, two stocks trading around $2 which we feel are underpriced. But there’s a catch, which we’ll reveal after a little more discussion. Firstly, though, we wish to point out that both stocks have remarkably similar market capitalisations (see Shoptalk below). Stock A’s is $2.5bn and Stock B’s is $2.4bn. That’s just a coincidence, but it’s an interesting fact given the concept we’re about to explore.

It’s now time to tell you the names of these two companies. The first, Stock A, is Macquarie Airports and the other is Leighton Holdings . We can almost hear the howls of protest from shrewd subscribers at this point: Leighton shares aren’t ‘around $2’—they’re ‘around $9’, which is of course correct. We simply divided Leighton’s share price by five.

Why? Because we want those people who prefer $2 stocks to more ‘expensive’ ones to realise that the share price, in isolation, offers no guidance to the company’s relative value. Remember that these two stocks have roughly the same market capitalisation, it’s just that Macquarie Airports has chosen to slice its ownership up into more pieces relative to Leighton. The former has 1.2bn units on issue where the latter has only 273m shares on issue.

If Leighton’s management wished, it could have a 5-for-1 share split and instantly create a ‘$2 stock’. But that wouldn’t change the company’s overall value one iota. It would still have the same contracts, the same management, the same challenges and the same opportunities. And it would have the same market capitalisation.

Underlying the view that a $2 stock is better than one with a nominally higher value is the often unspoken belief that it’s easier for a $2 stock to double than it is for a $10 one. But this is an argument based on emotion rather than logic. If Leighton invoked the fictitious share split described above, it would still be a $2.4bn company and need to increase its value by that much to double its stock price from $2 to $4—exactly the same position it’s in now with a share price of $8.93. If management creates an additional $2.4bn in value (without issuing new shares) then Leighton’s stock price will dutifully double to $18 in time.

One of our analysts had the misfortune to be working in an investment bank back in 2000 when Aristocrat (see page 7) split its stock four-for-one. The nominal share price duly fell from almost $18 to $4.50. One particularly naïve colleague at the bank suggested that the shares were a raging buy at the $4.50 level because, were they to go back to the $18 level, you would quadruple your money. In the now famous words of tennis player Andy Roddick: ‘thank you Captain Obvious’. The exact same mathematics would apply if the $18 shares rose to $72, an event which would have precisely the same economic impact.

For those who still don’t believe this to be the case, we submit as evidence Berkshire Hathaway shares. Warren Buffett’s company has shunned stock splits, but that hasn’t stopped its shares rising from US$8 to around US$90,000 over the past few decades. Buffett argues that a lower share price encourages higher share turnover and therefore higher brokerage costs. These costs reduce the wealth of all shareholders as a group. He is also cognisant of the quality of shareholders Berkshire attracts: ‘Could we really improve our shareholder group by trading some of our present clear-thinking members for impressionable new ones who, preferring paper to value, feel wealthier with nine $10 bills than with one $100 bill?’

Closer to home, Wesfarmers ’ last stock split was 15 years ago. And you’d be hard-pressed to find anyone who’s owned it over that period complaining. Its share price has risen from $4 to around $29 and the dividends and capital returns have been great too.

It’s a myth that lower priced stocks have more potential for gain. As long-term owners of bank stocks like Commonwealth, National and Macquarie will tell you, history has shown that an excellent $10 stock has a lot more chance of going to $30 than a poor quality $1 stock has of going to $3.