Identifying cheap stocks in the market seems like an obvious move to execute the buy low, sell high strategy, but it can lead investors down unexpectedly treacherous paths. Cheap stocks are often priced that way for a reason, and overloading on these names can expose investors to bad companies, low-growth industries, and cyclical time bombs. Consider the following when adding cheap stocks to your portfolio.
Nominal price per share should (usually) be irrelevant
Beginning investors might look at a $10 stock and determine that it is cheaper than a $20 stock since they can purchase more shares for the same dollar amount. In a simple sense, this is true, but that's a backward approach to portfolio creation.
Investors should determine an overall amount of savings that should be deployed into the stock market, then spread that amount across different investments in proportions based on an investment strategy. Thus, each stock should have a predetermined percentage allocation in a portfolio, and a certain number of shares should be purchased to reach that amount. This gives the investor control over exposure. If your portfolio is not large enough to allocate in proportion across different stocks, consider mutual funds or ETFs instead.
Moreover, analysis and allocation should be based on price relative to fundamental operating metrics of the underlying company, such as earnings per share (EPS), free cash flow, dividends per share, book value, or earnings before interest, taxes, depreciation, and amortization (EBITDA). A $10 stock for a company with meager $0.10 EPS and no growth is actually more expensive than a $20 stock that is reliably delivering stable $1 dividends every year. Analytical approaches to valuation provide a better understanding of pricing and keep people away from things like penny stocks.
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Cheap stocks can be value traps
Value traps are stocks that look enticingly cheap but are ultimately poor investments. Value traps can take different forms. Sometimes they are companies with growth potential that are unlikely to attain those levels, such as biotechs with one promising compound in clinical trials that won't beat competitors to market. Alternatively, a value trap could be a formerly successful company that is suffering operationally, starting a steady decline from which it will never recover. J.C. Penney was a famous example roughly a decade ago, and that stock looked incredibly cheap relative to retail peers for some time, but investors were justifiably fleeing a name that was experiencing drastic contractions that would eventually lead to bankruptcy.
There's no doubt that investors have some opportunities to capitalize on marginal mispricings in the stock market, or to take advantage of irrational behavior that can create attractive entry positions during tumult. That said, global capital markets are mostly efficient, and it's unlikely that the entire universe of fund managers, portfolio managers, artificial intelligence, and individual traders have simply overlooked the merits of a well-known stock. If your screens and analysis identify a valuation that's drastically too good to be true, then you should probably dig a little deeper.
Crisis-stricken industries, such as banking in 2009 or travel and hospitality in 2020, might experience so much uncertainty and investor flight that every stock in the group looks like a low-risk proposition. Some companies in those groups will almost certainly weather the storm and provide some outsized returns. Others will go out of business or get absorbed by larger competitors for unattractive valuations. Investors dabbling in these circumstances have to pick correctly, and the entire industry may emerge weaker or smaller than prior to the crisis. Similarly, situations arise when companies with operational concentration in certain countries become inexpensive, as geopolitical tensions, structural issues with a regional economy, or trade wars raise the likelihood of operational challenges in the upcoming years. Be wary of these traps.
Diversification can become a major problem
Portfolio diversification ensures that invested assets won't suffer too dramatically when unexpected bad times reach any specific industry, country, or type of stock. Focusing too heavily on cheap stocks creates serious impediments for diversification. Some industries, such as raw materials, industrials, banking, and non-cyclical consumer goods tend to maintain low valuation ratios, whereas certain technology and pharmaceutical stocks regularly carry high valuation ratios. The latter tend to have better growth prospects, so a focus on cheap stocks will rob investors of ample exposure to high growth opportunities.
That approach would also jeopardize performance during times in which those lower growth industries struggle. In general, investors should balance allocation between highly volatile and less volatile stocks, because each group has periods of superior returns across a full market cycle.
Finally, chasing cheap stocks can over-expose investors to cyclical companies in the wrong part of the economic cycle. Industries such as auto parts, steel, construction, or durable goods tend to produce their best financial results during the final quarters of economic cycles, but they suffer the most when recessions hit. The market is aware of this pattern, and these stocks often have cheap valuation ratios relative to historical averages right at cyclical peaks. This tends to be a bad time to buy, but a strategy of buying cheap stocks will lead investors directly into that misstep.
Ryan Downie has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
FAQs
Does Motley Fool beat the market? ›
Overall, the 144 Motley Fool stock picks from 2016 thru 2021 have an average return of 171% compared to the S&P500 average return of 92%. That means that The Motley Fool is beating the S&P500 by an average of 93% across 144 stocks!
Is it better to buy low priced stocks? ›The low-priced stocks are cheaper, and hence they are considered highly volatile. Naturally, they have higher to fall rapidly in price because they rise and fall in a short span and frequently. Hence, investors looking for security and stable stocks don't prefer low-priced stocks.
What is The Motley Fool strategy? ›The Motley Fool's approach to investing prioritizes buying and holding quality stocks for long periods of time. We focus the most on the business fundamentals of the companies in which we invest, rather than on their stocks' short-term price changes.
How many stocks should I own Motley Fool? ›The Motley Fool's position is that investors should own at least 25 different stocks. Diversifying your portfolio in the stock market is a good idea for investors because it decreases risk by ensuring that no single company has too much influence over the value of your holdings.
What is the best way to beat the stock market? ›Growth Investing
Some investors seek to outperform the market by investing in high-risk, high-return stocks. Such investors may seek to invest in shares of smaller and newer companies which may, at times, give higher returns than larger and more established companies.
GameStop Corp. (NYSE:GME) is a penny stock that made it big, joining others such as Amazon.com, Inc. (NASDAQ:AMZN), Advanced Micro Devices, Inc. (NASDAQ:AMD), and Tesla, Inc.
Why do people sell stocks when they are low? ›When a stock trades at a technical inflection point: When a stock trades near—and then breaks below—a multiyear low, it often portends additional losses ahead. In this case, it may make sense to sell the stock as soon as the technical level is breached on the downside.
Are penny stocks a good long term investment? ›While investing in penny stocks is a good idea for short-term gains, it should not be your long-term strategy. Penny stocks tend to be volatile, and you may find your investment worth less than what you initially invested in them after a few months or years.
What are the 4 investment strategies? ›- Growth investing. Growth investing focuses on selecting companies which are expected to grow at an above-average rate in the long term, even if the share price appears high. ...
- Value investing. ...
- Quality investing. ...
- Index investing. ...
- Buy and hold investing.
The number of stocks you should own depends on factors like time horizon and risk appetite. While there is no "perfect" portfolio size, the generally agreed upon number is 20 to 30 stocks. A diversification strategy ensures that your money stays safe if one or a few assets dip.
How much should I invest in stocks to be a Millionaire? ›
$1 Million the Hard Way
If you're starting from scratch, online millionaire calculators (which return a variety of results given the same inputs) estimate that you'll need to save anywhere from $13,000 to $15,500 a month and invest it wisely enough to earn an average of 10% a year.
Depending on which research you pull, you can find arguments suggesting that anywhere between 10 and 60 individual stocks will make up a well-diversified series of investments. However, for investors looking for a rule of thumb, we would suggest considering this from a budget-first perspective: Invest with funds.
Who is the most accurate stock picker? ›- The Motley Fool Stock Advisor.
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So what do they mean by this “All In” buy signal? Basically, it just means a stock that they like so much, they've recommended it more than once.
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What is the fastest way to get rich in the stock market? ›Day Trade. If you're a nimble and proficient trader, probably the "easiest" way to make fast money in the stock market is to become a day trader. A day trader moves in and out of a stock rapidly within a single day, sometimes making multiple transactions in the same security on the same day.
Why is the S&P 500 so hard to beat? ›A prime reason is that the skewed pattern of market returns stacks the odds against investors. Typically, a few high-performing stocks pull the average up, while the majority of stocks under-perform. Thus, buying and owning a few individual stocks will usually lead to poor performance.
How do you get rich off stocks fast? ›- Develop an Investing Strategy. Your investment strategy is a set of rules or guidelines to help you decide when you should or shouldn't invest. ...
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- 1.1 GameStop (NYSE: GME)
- 1.2 Sundial Growers Inc (NASDAQ: SNDL)
- 1.3 Castor Maritime (NASDAQ: CTRM)
- 1.4 AMC Entertainment Holdings Inc. ( NYSE: AMC)
Examples of stocks that went to zero
Enron was trading at $0.26 just before it declared bankruptcy in December 2001. WorldCom. This telecommunications company perpetrated the largest accounting fraud in U.S history, causing one of the biggest bankruptcies.
What's the biggest stock jump in one day? ›
| Rank | Date | Change |
|---|---|---|
| Net | ||
| 1 | 1933-03-15 | +8.26 |
| 2 | 1931-10-06 | +12.86 |
| 3 | 1929-10-30 | +28.40 |
9:30–9:40 a.m. Stocks that open higher or lower than they closed typically continue rising or falling for the first five to 10 minutes… 9:40–10:00 a.m. … before reversing course for the next 20 minutes—unless the overnight news was especially significant.
At what age should you get out of the stock market? ›You probably want to hang it up around the age of 70, if not before. That's not only because, by that age, you are aiming to conserve what you've got more than you are aiming to make more, so you're probably moving more money into bonds, or an immediate lifetime annuity.
Who buys stocks when everyone is selling? ›Brokers and Market Makers
Some firms that offer brokerage services are also market makers. Market makers are there to help facilitate trade so there are buyers and sellers in stocks listed on the major exchanges. This doesn't mean they will always give a good price—they are just providing some liquidity.
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- Best Penny Stocks To Buy Right Now In India 2023.
- Suzlon Energy Ltd.
- South Indian Bank.
- Reliance Power.
- Vodafone Idea.
- Bank of Maharashtra.
- Features of Penny Stocks.
It is possible to make money with penny stocks. Then again, it's technically possible to make money with any type of stock. Successful investors usually focus on the potential for their stock picks, regardless of price, to gain value over the long term. There are plenty of good reasons to invest in small companies.
What are the safest penny stocks to buy? ›- Vodafone Idea.
- Suzlon Energy.
- Alok Industries.
- Hemang Resources.
- Indian Overseas Bank.
Buffett uses compound interest, dividend reinvestment, and the power of constantly reinvesting the operating cash flow generated by Berkshire's businesses to his advantage. How powerful is this? Berkshire has averaged a 20.1% annualized return since Buffett took over in 1964, compared with 10.5% for the S&P 500.
Which investment strategy carries the most risk? ›Equities are generally considered the riskiest class of assets. Dividends aside, they offer no guarantees, and investors' money is subject to the successes and failures of private businesses in a fiercely competitive marketplace. Equity investing involves buying stock in a private company or group of companies.
Is it a good idea to buy more stock at a higher price? ›Average up refers to the process of buying additional shares of a stock one already owns, but at a higher price. Averaging up can be an attractive strategy to take advantage of momentum in a rising market or where an investor believes a stock's price will rise.
Is it better to hold a stock or sell high and buy low? ›
Try to Beat the Market
If an investor is skilled in timing their trades, consistently buying low and selling high, they have a better chance of beating the market than investors who buy and hold. That is why this method is often preferable for active traders who forgo a passive or indexing approach to investing.
Should you buy a stock at a 52 week low? Many investors prefer to buy undervalued stocks, as it is believed that there is a high chance of such stocks to go higher in the future. For such investors, selecting a company from the 52 week low list randomly and merely based on the 52 week low information may work.
Why is buying low good? ›“Buy low, sell high” is an investment philosophy that advocates buying stocks or other securities at a lower price than you can later sell them. This is the opposite of buying high and selling low, which effectively results in investors selling stocks at a loss.
How much money should I invest in stocks as a beginner? ›Experts typically advise you to invest 10-12% of your annual income in stocks. So if you make $50K a year, you'll want to set aside around $400 a month to invest with. That's about $4,800 a year. Of course, when it comes to investing, you also should consider your comfort level– how much risk do you want to take on?
What day of the month are stocks cheapest? ›Stock prices tend to fall in the middle of the month. So a trader might benefit from timing stock buys near a month's midpoint—the 10th to the 15th, for example. The best day to sell stocks would probably be within the five days around the turn of the month.
What day of the week are stocks cheapest? ›May be the best time of week to sell shares: Friday
Whether because of weekend optimism or because Saturday and Sunday's news hasn't been priced into the market yet, many traders feel that Fridays see stocks and indices priced higher.
The fifty percent principle is a rule of thumb that anticipates the size of a technical correction. The fifty percent principle states that when a stock or other asset begins to fall after a period of rapid gains, it will lose at least 50% of its most recent gains before the price begins advancing again.