Should You Resort to Buying Cheap Stocks Based on Absolute Price?

Stocks

If you’re new to the stock market, then you have probably set your sights on low-priced stocks.

But the question is: are they worth it?

Will buying cheap stocks based on absolute price help your portfolio? Or will they destroy your otherwise fantastic investment strategy?

Before you go ahead and buy one, make sure to read the pointers below.

What is a Cheap Stock, Anyway?

When it comes to cheap stocks, ‘penny stocks’ immediately come to mind.

The name easily describes itself—they’re stocks you can buy for under a penny. Just think of Elite Pharmaceutical, which you can buy for 37 cents a share.

Apart from the popular penny stock, there are some that trade at a low absolute dollar figure. A good example is Hudson City Bancorp, which you can buy for $9.

That said, price isn’t the only thing that makes cheap stocks, well, low-priced.

The stock is considered cheap if it trades below 50% of its pegged amount. In essence, not all stocks that are cheap are inexpensive.

Case in point: buying Berkshire Hathaway stock, specifically the class A ones. This will set you back $200,000 a share—cheap compared to its value of $400,000+ each!

Why Buy Penny Stocks? The Psychology Behind this Unique Investing Strategy

Investors often ask this question to so many money managers: why would you sell a valuable stock at a meager price?

According to experts, it all boils down to these four things:

  • Greed

No one can predict the future. However, some try to predict earnings, stocks, and other variables according to the current market climate.

While some come true, most of the time, they don’t. They end up becoming worthless stock, which is why owners will do anything to get rid of them.

  • Fear

Once the stock quotes begin to take a slow, steady slide, the fear envelopes investors. Some are worried that the tumbling prices will take their entire life savings along with them.

So while there’s still some net current asset value, many will sell them while they can.

  • Pain

This specific investment strategy brings more than just fear—it leads to pain as well.

Each stock represents the pain of losing everything. So instead of dealing with them, investors will sell them for cheap.

  • Pessimism

Even if you have high-dividend yielding stocks at hand, investors get to be pessimistic about it. Because of the lack of buyers and sellers, they will try to eliminate all of them.

Should You Buy Cheap Stocks?

Yes, because they yield spectacular returns.

Below, you’ll see the value of buying cheap stocks relative to the following:

Dividend Yield

For best results, you should buy cheap stocks relative to the share price. They should be higher-dividend yielding stocks, otherwise known as large dividend yield stocks.

According to a study by the Tweedy Browne Company, these stocks bring better yields in due time. That’s because they get to beat the market by significant amounts.

Earnings

Another way that cheap stocks dominate the market is through earnings.

Make sure to buy low price relative to earning stocks, otherwise known as low PE stocks. According to another Tweedy Browne study, they can give you high returns in the years to come.

In fact, these stocks dominated from 1957 to 1971, even with the rapidly-sinking stock market.

Cash Flows

Another strategy is to look at the stock price relative to the money that the company has brought.

For top money management firms, cash flow is the best way to measure profit. That’s because it represents the money and not just the accounted profit.

Tweedy Browne’s above-cited study also proves this to be true. Results showed that such stocks outperformed their peers over time.

Net Assets

This method is all about buying stocks that come with a low price-to-equity value.

It’s good to do stock trading when the company’s share price is below the share equity.

Another advantage of this cheap stocks sub-strategy is that assets prove to be more stable than the company’s net earnings. The latter can be inflated but not assets.

Cheap Stocks Win a Lot, But be Careful

Some money managers fail with penny stocks because of the risks inherent to them. So before you make a trade, you should be on the lookout for the pump and dump scam.

This occurs when people purchase penny stocks at meager prices. They hype the company to help increase the share value.

Because of this, buyers rush in to buy the stocks, most of which are sold at high prices. The result: tremendous losses on the part of the buyer.

That said, make sure to assess the intrinsic value before taking a dive. When it comes to this fantastic value investing strategy, knowledge is power.

Final Thoughts

As you’ll see, buying a low absolute dollar amount stock offers high dividend yields. They have a proven high-performance record, as the Tweedy Browne studies above show.

Buying cheap stocks is the best investment strategy right now, so make sure to try it!

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.