Home Investing Why Purchasing Cheap Stocks Could Be A Wrong Investment Strategy

Why Purchasing Cheap Stocks Could Be A Wrong Investment Strategy

by Michael Webb

Identifying the market’s cheap stocks seems like an easy step to conduct low buy, sell high strategy, but it may take investors down surprisingly treacherous paths. For a purpose, cheap stocks are always priced so, and overloading on these names will expose investors to bad firms, low-growth sectors, and cyclical time bombs. Consider adding cheap stocks to your portfolio.

Nominal Price per Share (Usually) Should Be Insignificant

Beginning investors can look at a $10 stock and decide it’s cheaper than a $20 stock, as they can buy more shares for the same dollar. Simply put, that’s true, but it’s a backward approach to portfolio growth.

Investors can decide an aggregate amount of savings to be deployed on the stock market, then spread that amount across various assets in proportions dependent on investment strategy. Thus, each stock should have a fixed percentage allocation in a portfolio and purchase a number of shares to achieve that sum. This gives investor exposure power. If your portfolio is not big enough to spread through various securities, consider mutual funds or ETFs instead.

In addition, valuation and allocation should be based on the underlying company’s basic operating metrics 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 meager $0.10 EPS firm, and no growth is actually more expensive than a $20 stock that produces steady $1 dividends annually. Analytical valuation methods include a better view of pricing and drive people away from penny stocks.

Cheap Stocks May Be Value Traps

Value traps are stocks that look enticingly cheap, but actually weak. Value traps can take various forms. Often they’re companies with growth potential who are unlikely to hit those heights, such as biotech with one successful compound in clinical trials who won’t beat business rivals. Alternatively, a value trap may be an operationally struggling formerly profitable company, beginning a steady decline from which it would never recover. J.C. J.C. Penney was a popular example about a decade ago, and for some time the stock looked incredibly cheap compared to retail peers, but investors fled a name the suffered dramatic contractions that ultimately led to bankruptcy.

There is no question that investors can capitalize on marginal stock market mispricing or take advantage of irrational actions that can build attractive entry positions during tumult. That said, global capital markets are mostly effective, and the entire universe of fund managers, portfolio managers, artificial intelligence, and individual traders are unlikely to have simply overlooked the merits of a well-known stock. If your screens and research detect a valuation that’s too good to be true, you should probably dig a little deeper.

Crisis-stricken industries, such as 2009 banking or 2020 travel and hospitality, could experience so much volatility and investor flight that any stock in the group looks like a low-risk proposal. Any businesses in those categories would almost certainly weather the storm and give outsized returns. Others may exit or be absorbed for unattractive valuations by larger rivals. Investors dabbling in these circumstances must choose correctly, and the whole industry could emerge poorer or smaller than before the crisis. Similarly, situations occur when firms with operational concentration in some countries become cheap, as global conflicts, structural problems with a regional economy, or trade wars increase the possibility of operational difficulties in the coming years. Beware of these pitfalls.

Diversification Could Become a Major Problem

Portfolio diversification ensures that invested assets do not suffer too drastically when unforeseen hard times hit any particular sector, region, or stock type. Focusing too much on cheap stocks creates serious distinction barriers. Some sectors, such as raw materials, sectors, finance, and non-cyclical consumer goods, tend to retain low valuation ratios, whereas some technology and pharmaceutical stocks bear high valuation ratios routinely. The latter appears to have better growth prospects, so betting on cheap stocks would deprive large-scale investors of high growth opportunities.

The approach will also jeopardize efficiency when those lower growth industries struggle. Investors should typically balance allocation between highly volatile and less volatile stocks, since each category has periods of higher returns over a full market cycle.

Final Thoughts

Finally, in the wrong part of the economic cycle, chasing cheap stocks will over-expose investors to cyclical firms. Industries such as automotive parts, steel, manufacturing, or durable goods tend to yield their best financial results in the final quarters of economic cycles, but they struggle most when recessions strike. The market knows this trend, and at cyclical peaks these stocks also have cheap valuation ratios compared to historical averages. This appears to be a poor time to buy, but a plan to buy cheap stocks will lead investors into that mistake.

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