Topic: Growth Stocks

Why you don’t want to buy some cheap stocks

Investors who go out of their way to buy cheap stocks sometimes find themselves with stocks that are headed in the wrong direction

Investing in penny stocks—which trade for under five dollars a share, and as the name implies, sometimes for pennies—is one way to buy cheap stocks. But you need to be very careful. Penny stocks do sometimes pay off, but there are many pitfalls to avoid. You should be aware that many penny stocks are little more than very well executed marketing campaigns. Penny stock promoters will do anything in their power to get their penny stock noticed, including TV interviews, podcasts, newsletters and other paid sponsorships.

But stock bargain hunting doesn’t always mean penny stocks. Many investors seek out “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to its sales, earnings or assets). One of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” and then hold on to them as mainstream investors recognize the value and push up the share price.

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These bargain stocks will trade lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many new tech stocks, for instance, start out as growth stocks and transition into value stocks. They have low price-to-earnings and price-to-book ratios—which is why they’re less expensive than growth stocks. Due to this fundamental distinction, a value stock is often traded at a more affordable price than a growth stock.

Some investors see companies that fall into this category as undervalued. These investors are less likely to invest in a growth stock because they feel that the value stock will eventually reach its full potential once it is recognized by the market.

Generally speaking, the climb is steadier for value stocks. The only other way for it to emerge into the market like a growth stock is for it to be a bit more innovative with its products or services.

When you buy cheap stocks, they may be worth only what you pay—you can’t negotiate a favourable purchase price

Investors who “bargain shop” for stocks explain that they are simply looking to buy stocks like a smart consumer would buy a car. But they overlook one key difference. Car prices do vary, and some buyers do pay less than others, because they have better bargaining skills and more time to spend shopping around.

However, the stock market is more efficient than the car market, as an economist would put it. You can’t negotiate a favourable price for a stock. To get a lower price, you have to wait for the stock’s price to come down.

Aim for a deal when you buy cheap stocks and be left open to a double risk

Two-part investing exposes you to a double risk. Seemingly attractive stocks can drop for months, or even years, before a hidden flaw comes to the surface and explains their weakness.

For that matter, little-noticed stocks sometimes rise for months before the reason for their strength becomes apparent. In a lifetime of investing, you’ll choose both kinds of stocks.

If you always try to buy below the market, you’ll always get a “fill” on stocks with hidden flaws. They’ll always come down into your buying range ….and they’ll keep on falling.

But you’ll never get to buy the other kind of stock—the kind that keeps going up. These stocks will always seem too expensive, and they’ll go on to get even more expensive. But you need a few of these ever-more expensive stocks to offset the losses from those that get cheaper and cheaper.

There’s no easy answer to the buy-now-or-wait dilemma. At times it may pay to hold off—for instance, a company’s stock will often rise when it announces a stock split, then fall after the split takes effect.

In the end, if a stock is truly worth investing in, you should be willing to buy it at current prices, even if that means you run the risk of having to sit through a 5% to 10% setback. Before it slips into its next 5% to 10% setback, after all, it may first go up 50% to 100%.

Does the current share price figure prominently in your stock-buying decisions? Have you bought stocks at prices higher than you liked, yet been rewarded when the price went up? Or have you bought stocks “on a dip” only to see them get significantly cheaper?


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