Click Here to Get Your FREE Video Training Now!
Twitter
LinkedIn
YouTube
RSS
Facebook

About Profitable Investing Tips

Profitable Investing Tips has been a member since April 20th 2008, and has created 163 posts from scratch.

Profitable Investing Tips's Bio

Profitable Investing Tips's Websites

This Author's Website is

Profitable Investing Tips's Recent Articles

Can Passive Investment Be Risky?

Over just the last few years the proportion of the US stock market that is invested passively has moved up to 45%. Investors are attracted to ETFs (exchange traded funds) because of their low overhead. And, many have outperformed actively traded vehicles like mutual funds and other actively managed investment vehicles. But, can passive investment be risky?

Passive Investment Is on the Rise in the US Stock Market

CNBC reported that passive investing automatically tracking indexes has risen to nearly half of the US stock market.

Passive investing, made up of funds tracking market barometers, has now taken over nearly half the stock market as more investors shun stock-pickers and flock to index funds.

Market share for passively managed funds has risen to 45 percent, up a full point from June 2018, according to data this week from Bank of America Merrill Lynch. That continues a trend over the past decade in which investors have moved to indexing, particularly through exchange-traded funds.

Despite the risks that some see in this approach, investors are pleased with the results and are even applying it to buying bonds! But, can passive investment be risky? It turns out that there are valid concerns. But, first, just what investment vehicles are we talking about?

 

More and more investors are putting their money into vehicles like ETFs that track market indexes but can passive investment be risky?

Active versus Passive Investment Management

 

Passive Investment Funds versus Active Investment

Investopedia discusses active versus passive investing.

Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond or any asset.

This investment approach obviously applies to when you choose stocks yourself using an approach like intrinsic stock value. It also applies to when an investment professional oversees a fund that invests in millions or billions of dollars in stock investments.

If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.

The prime example of a passive approach is to buy an index fund that follows one of the major indices like the S&P 500 or Dow Jones.

Such investments have become popular for three main reasons. Their fees are very low because no one is getting paid to research stocks to buy and sell, an investor always knows exactly what investments are in the fund, and because there is not a lot of buying and selling, investors are not paying a lot of taxes on capital gains every year!

The Value of the Passive Investment Approach

As noted, funds that track the S&P 500 and other indexes are cheap to run and this fact shows up in a lower “investing overhead” for the passive investor. In the last few years as the bull market has exploded in the aftermath of the Great Recession the passive approach has made excellent money and often out-performed many active investors.

Here are three very large funds that qualify as passive investment vehicles.

SPDR S&P 500 ETF (SPY)

This vehicle is a unit investment trust that manages about $280 Billion in assets. It is up six times its initial value per share in 1993. Because of its huge size this fund is very liquid for those who choose to buy and sell. And, it has performed very well for passive buy and hold investors.

 

Can passive investment be risky? Take a look a the ups and downs of the SPFR over the years.

SPDR S&P 500 ETF (SPY)

 

iShares Core S&P 500 ETF (IVV)

iShares is an ETF that manages about $165 Billion by tracking the S&P 500. It can be traded like a single stock for those who wish to buy and sell and has been good to buy and hold passive investors. IShares is trading at three times its single share value at the depths of the stock market crash but is less than double what it started at in 2000.

 

This fund has been doing well but can passive investment be risky? Notice that the fund has fallen as well as risen.

iShares Core S&P 500 ETF (IVV)

 

Vanguard S&P 500 ETF (VOO)

This fund is a true ETF that manages about $106 Billion. Is the newest of the three having begun in 2010 although Vanguard has been around for a long, long time. The shares are up to 250% of their original value.

 

The Passive Investment fund has been doing great for 9 years but can passive investment be risky? Look at what happened last December!

Vanguard S&P 500 ETF (VOO)

 

As can be seen, these three funds are managing half a trillion dollars in stocks. The total S&KP 500 market cap is about $22 Trillion and the total US stock market cap is around $30 trillion. But, remember that there are a lot more such vehicles as of today they manage nearly half of all US stock market equity.

Now, what is the down side of this approach?

Can Passive Investments Be Risky?

Critics of the current infatuation with passive investing say that the great bull market since the Great Recession has strongly influenced our view of these investments.

Passive Investments Can Be Inflexible

First of all, these vehicles track the market and are up because the market is up. When the market falls, so will they! Warren Buffet pulled a lot of investments out of the market and held a large amount of cash just before the dot com crash. He said the market did not make any sense. He did not lose when the market crashed and was ready with lots of cash to buy bargains as the market recovered. ETFs and other passive investment vehicles will not and cannot do this as they are forced to buy and sell to maintain a mix of stocks that reflects the index that they track!

Passive Investment Vehicles May Need to Sell into a Falling Market

When the next crash comes, and it will, a well-structured ETF that tracks the S&P 500 could weather the storm and recover. But, what if its investors panic? On a normal day these funds buy and sell to adjust their mix of stocks. If just one in ten of their investors want to cash out, the selling will drive the share price lower and lower. And, as the market in general goes down, the mix of shares making up any given index may shift dramatically. This sets up a scenario where the fund needs to buy and sell in large volumes and not as efficiently as they would normally. And, as the value of the fund’s shares fall there is likely to be panic among novice investors who have never seen a real crash. The end result could be a race to the bottom in share prices of the ETFs and the market!

Active Investors “Police the Market” While Passive Investors Are Along for the Ride

The eventual price of any stock is determined by its intrinsic value. It is the pool of active investors and especially the investing professionals who use fundamental analysis to determine how much a stock is worth and will be worth going forward. When more and more investors follow the passive route, the determination of intrinsic stock value is being done by an increasingly small portion of the market. This sets the market up for the herd effect which is all too often seen in offshore investing but increasingly affects US markets.

Is Passive Investing Worth the Risk or Not?

The responsibility of the average investor is not to his or her fund, pension plan, or other vehicle with lots of passive investors depending on his or her decisions. The responsibility of the average investor is to his own best interests. For the time being, passive investment vehicles are still doing well and, unless you have some great ideas about what else to invest in, leaving things as they are is an option.

If you worry that the market may correct more strongly or crash, it might be a good idea to diversify a little. Some time back, we wrote about how to invest without losing any money. With this approach an investor will take of portion of his stocks or ETF shares and sell. Then he or she will buy CDs at the bank, US Treasuries, AAA corporate bonds, or a handful of stocks carefully chosen to successfully ride out a market downturn.

If you are a passive investor, it is not your responsibility to worry about how passive investing affects the market as a whole. But, you need to be aware that a passive investment can be risky and take some sensible precautions.

Investing in Stocks

The reason for investing in stocks is to attain financial security. While some people may make a spectacular investment decision by chance, the vast majority who succeed at investing in stocks save their money and invest over a long period of time. Success in investing starts with defining your goals. What do you want to get out of investing? Make a list with the most important goals like having enough money for retirement, putting your children through college, or saving up to start your own business at the top of the list. Then consider how many years are left for you to attain each of these goals. The point is that your choice of investments needs to fit the available time frame.

(U.S. Securities and Exchange Commission: Define Your Goals)

The best returns on investment over the years come from routine stock investments.

Investing in Stocks

Investing in stocks needs to be part of your total financial strategy. Before you start putting money into the stock market, pay off your credit card debt. A typical interest rate on credit card debt is 24% per year. You are not likely to get this rate of return as a novice investor, so pay off your credit cards before investing in stocks. And, put three months-worth of expenses in the bank so that you are not continually selling your stocks to cover routine living expenses! Now you are ready to consider how to invest.

Investing in Stocks vs Bonds

For those who have heard the horror stories of folks losing everything in the 2008 stock market crash and financial crisis, how to invest without losing any money is a major issue. As we note in our article about investing and not losing money, a portion of your investment portfolio should be conservative. A simple way to do this is to purchase certificates of deposit at your bank. These are protected against loss up to $250,000 per depositor per bank by the Federal Deposit Insurance Corporation, an agency of the U.S. government.

(FDIC: Deposit Insurance at a Glance)

Alternatively, U.S. Treasuries are backed by the “full faith and credit” of the U.S. government and will not result in any losses if held to maturity. The next conservative investment in line is an AAA corporate bond. The two U.S. corporations with this bond rating are Microsoft and Johnson & Johnson.

 

Besides investing in stocks, consider AAA corporate bonds like Microsoft of Johnson & Johnson

Microsoft Logo

 

But, in order to attain your goals you probably need to get a larger return on investment than with these conservative vehicles. Over the years, stocks have offered the most potential for growth.

(Fidelity: Three Reasons to Invest in Stocks)

This brings us to the mechanics of investing stocks. The best approach according to most experts is to allocate a set amount of money with each paycheck, every quarter or annually as money becomes available. Then, which is best, investing in stocks now or later, investing in stocks with dividends, letting a mutual fund do your investing for you, putting your money in index funds, or simply investing in stocks online by yourself.

Investing in Stocks Now

Once you have put your financial house in order it is time to invest in stocks. When you invest early in life you get to take advantage of the exponential growth of wise investments. The rationale is that a well-chosen investment in the stock market may appreciate as much as 12% a year on the average. When you leave this investment in place you benefit from the “rule of 72.” Divide the number 72 by your average yearly percent return on an investment. This gives you the number of years required to double that investment!

With a common stock whose appreciation plus dividends come to 12% on the average it will take six years to double your money. Start investing in stocks now when you are 25 years old and you will have seven x six = 42 years until you reach age 67. Double your investment seven times and you will get a 2x2x2x2x2x2x2=128 fold appreciation on your initial investment! The $100 that you invest in a well-chosen stock at age 25 could be worth 128 x $100 = $12,800 and that is just the $100 that you invested in one month.

The basic reason that investing in stocks builds wealth better over the long term is that with stocks you get more “doublings” over the years when you start early and continue over the years.

(Investopedia: Rule 72)

Investing in Stocks with Dividends

In our article about dividend stocks, we note that some companies have routinely paid dividends for more than a century. Not only is such an accomplishment an indication of the safety of such investments but when dividends are reinvested and added to the usual stock appreciation it makes “rule 72” work faster! Look for companies with dividend reinvestment plans when considering dividend stocks.

Investing in Stocks vs Index Funds

Although we would like to think we can pick the best investments, even experienced fund managers can have a hard time beating the S&P 500 over the years. As such, many investors choose a fund that tracks a major stock index like the S&P 500 or a sub-category of the S&P 500 such as consumer staples, consumer discretionary, energy, communication services, financials, health care, industrials, materials, information technology, real estate, and utilities. And, there are many sub-sectors within each of these categories as well. We commonly suggest that if you are picking your own investments that you should start with things that you know about as your knowledge and insights will give you an advantage over other investors.

(The Balance: Sectors and Industries of the S&P 500)

 

A good option when investing in stocks is to simply invest in an index that tracks the S&P 500

S&P 500 All Through January 2019

 

Investing in Stocks Short Term vs Long Term

Short term investing requires skill at market timing. Basically, you need to recognize an opportunity early in the game, make your investment, and then sell when the stock reaches a plateau or starts to fade. There are investors whose only method of investing in stocks is this approach. While some of these folks do very well, many routinely lose money chasing an elusive dream. When an investor repeatedly buys and sells stocks he or she incurs a cost with every transaction. Fees and commissions can eat up what would otherwise be moderate profits. This is the main reason why old, rich investing legends like Warren Buffett do not try to time the market. Rather they look for long term value and unique buying opportunities.

Long term investors know that the eventual price of a stock is determined by its intrinsic stock value. This is the value of the stock based on its projected future earnings. Successful long term investors only invest in stocks when they clearly understand how the company makes money and how their business plan will result in continued earnings into the distant future. Carrying this approach to success requires a bit of homework and patience. Imitating the investment portfolios of the most successful investors like Buffett is a place to start. Buffett himself has said that as he and his team look for clear indications of strong intrinsic stock value they end up throwing out 19 out of 20 possible investments.

 

When investing stocks a good way to start is to copy the investments of "old pros" like Warren Buffett and buy stocks like coca cola

Coca Cola

 

The best way to start with this method is by imitation of successful investors and then add more investments of your own as you gain experience. A key factor is to keep track of what you have in your portfolio and use the intrinsic value calculation contained in our article to not only decide what to buy when investing in stocks but what to unload when the company’s business plan is no longer working!

Investing in Stocks vs Mutual Funds

Many folks have the money and want to save and invest for retirement, sending the kids to college, or being able to afford to live the life they always dreamed. These same folks may well be too busy with their work and their lives to devote sufficient time and effort to making and following their investments with the degree of skill and attention that they deserve. Many of these folks will look for someone to invest for them. One approach is a mutual fund. Fidelity explains what a mutual fund is.

Mutual funds are investments that pool your money together with other investors to purchase shares of a collection of stocks, bonds, or other securities, referred to as a portfolio, that might be difficult to recreate on your own. Mutual funds are typically overseen by a portfolio manager.

(Fidelity: What Are Mutual Funds?)

There are several advantages to investing in a mutual fund instead of directly investing in stocks. First of all, stocks like Amazon.com sell for more than $1,700 a share and shares of Warren Buffett’s Berkshire Hathaway Class A stock sell for more than $300,000 a share! These are good investments and anyone who is routinely investing $100 a month cannot buy a single share. But, a mutual fund can and they do. A well-managed mutual fund invests in a range of stocks, bonds, and other investments to provide a good return on investment for the investors in the fund.

The “downsides” to investing in a mutual fund are two. The investor pays a fee to have his or her money “managed” by the fund. And, all too often, a mutual fund does not outperform an index fund that tracks the S&P 500! But, if you do not have the time and energy to do your own investing in stocks, consider a well-managed mutual fund with low fees or simply put your money into an index fund that tracks the S&P 500.

Investing in Stocks Online

For many investors, the old days of going through a traditional stockbroker for investing in stocks are gone. Today many if not most investors use an online stock broker. A good online broker offers research capabilities and often does not require an account minimum and does not charge annual fees like a mutual fund would. Popular online brokers include Vanguard, E-Trade, Fidelity, Charles Schwab, Ameritrade, and Merrill Edge. The same principles apply to investing in stocks online as to investing through a broker. On one hand, you will not be sold a “bill of goods” on a stock by a broker who is “pushing” it this week, which is a good thing. And, on the other hand, you will not have a wise old investment pro to guide you towards good investment choices and away from bad ones either.

Is Investing in Stocks Worth It?

Some folks will read this article and think that investing in stocks sounds like a lot of work. They will rightfully wonder if it is worth it to invest in stocks rather than simply putting their money in U.S. Treasuries or CDs in their bank. The truth of the matter is that if you are building an investment portfolio for retirement, to start your own business, to pay for college, and to live the life of your dreams, you need a balanced investment portfolio.

This means putting some money in the bank, building a ladder of CDs, purchasing US treasuries and AA corporate bonds, and investing in stocks. Always remember that you need to balance safety with the power to grow your investments. However, the “rule of 7” works best for well-chosen stocks. If you are not up to the challenge of picking your own individual stocks due to time constraints, go with index funds or swallow hard and pick a mutual fund.

How to Spot a Value Trap Investment

Over the years we have often cautioned investors to beware of penny stocks, especially those that have seen better days. While investing in a grand old name in hopes of a recovery it is important to learn how to spot a value trap investment. This issue came up recently when we wondered what was wrong at Kraft Heinz. As bargains become harder to find in an aging bull market there is a temptation to go bottom feeding in search of an investment miracle. Here is some advice about what to watch out for.

 

If you are going to invest in Kraft Heinz today you need to know how to spot a value trap investment.

Kraft Heinz Products

 

Spotting a Value Trap

A couple of years back Bloomberg published a useful article with 12 signs a cheap stock is a value trap.

The historically high price-to-earnings ratios being placed on equities today make cheap stocks even more alluring. That makes sense, but be advised that the market is littered with “value traps” or stocks that look cheap but never substantially rebound.

Any way you cut it, value is profoundly out of favor, and not just in 2017. Although proponents of these investments typically are patient people, the long-term differential is large enough to be worrisome. Over the last 10 years, growth has outperformed value by more than 100 percent in small caps and by 50 percent in large caps.

Thus, knowing how to spot a value trap is doubly important at this time. Here are dozen suggestions from Bloomberg. The ideas are theirs but rewritten by us for the sake of brevity.

Still Troubled at the Top of Its Operating Cycle

The U.S. economy and the vast majority of stocks have long recovered from the 2008 stock market crash and financial crisis. If the company you are looking at is performing poorly in the best of times it may well be a value trap. Something is wrong as is not being fixed or cannot be repaired.

Low Profits but High Management Compensation

When a company falls on hard times it typically puts the screws to management by cutting salaries and tying compensation benefits to performance. When this is not the case, management is milking the company for every last dollar before bailing out. This is a strong sign of the stock being a value trap.

Lack of Fresh Insights

When an industry like the U.S. auto industry is centered in one city or area like Detroit, everyone works with and socializes with like-minded people. But, when fresh ideas are needed this can be a real hindrance and create value traps of otherwise strong companies.

Market Share Continues to Slip

When someone else starts taking market share away from an old stalwart, you need to see them fighting with all that they have to regain that share and succeeding. Otherwise, they have become a value trap.

Too Many Fingers in the Pie

Many times a well-established company has many stakeholders such as labor unions, foundations, or old family control. The goals of these folks may not be consistent with a good return on investment by those who hold their stock. Consider such companies to be value traps until proven otherwise.

Not Managing Capital Effectively

A company that has historically been a cash cow may have gotten by for years by just putting money in the bank instead of reinvesting in R&D, acquisitions, and the like. When this company starts to slip it needs to shift gears or it is a value trap. And, the changes in how they manage capital need to be clearly articulated to investors and need to begin to show results.

Fat and Inefficient Management Structure

It is said that when Sears built the Sears Tower that they took up 22 floors for management, each floor a different level. No one was paying attention to how management was being carried out and no one was making changes. When a company does not upgrade and modernize how it operates on the day by day and decision by decision level, it becomes a value trap because its competitors will outperform it every day of the year.

Unrealistic and Fantasy Management Goals

When a company is in trouble it needs to regroup and it needs to explain those plans to both employees and investors. When management’s new goals are simply unrealistic no good will come of them. You can often see this by looking at old financial statements and the goals articulated in previous years and the fact that nothing useful has happened, ever! This situation is a clear sign that the company is a huge value trap. The better situation is when management promises a little but delivers a lot on a recurring basis.

Too Much Debt

The final nail in the coffin of most struggling companies is that they cannot pay their mounting debts with their dwindling cash flow. No matter how hard they try, how creative they are, and how much they economize, excessive debt is a killer and makes a stock a value trap.

Muddled Thinking and Poor Insight

The so-called strategic vision or the company is all muddled or simply lacking. When management’s plans for the coming years ramble on and repeat themselves, it is time to consider that stock a value trap, absorb your losses, and move on.

Split Attention between CEO and Board Chairman Responsibilities

When it is time to turn around a failing company it takes all of the time and attention that the CEO has. When he is spending a third of the time answering to the board of directors when he or she should be making changes from the ground up that is a sign of impending failure. Turnarounds need the full attention of the CEO or they become and remain value traps.

The Takeover Activists Are Nowhere in Sight

When a company has been mismanaged but has a lot of hidden value, there is always a Carl Icahn or his clone interested. When nobody shows up, that is a clear sign that the company really is a value trap and you should avoid it as well!

How to Spot a Value Trap Investment

The tips provided by Bloomberg are useful in spotting and avoiding a value trap. They all fall into the categories of fundamental analysis and evaluation of intrinsic stock value. While growth stocks have been leading the market in the last few years, there is a definite place for value in your portfolio. The trick is recognizing true and lasting value in an investment by understanding and appreciating how a company makes its money and how it will continue to do so well into the future.

 

How to spot a value trap is to consider the story of Eastman Kodak's rise to dominance and eventual decline.

Eastman Kodak

Is Your Investment Story Profitable?

Successful investors have a story that drives their investment decisions. A prime example is Warren Buffett who notes that the U.S. stock market prospers on the back of a growing U.S. economy. He looks for companies that reliably generate profits year after year and is a disciple of the intrinsic stock value approach to investing as he was, in fact, a student of Benjamin Graham who discovered that approach. So, the man who is perhaps the most successful investor of all time has a simple story that drives his investing. Is your investment story profitable?

Simple Investment Stories

The concept of investment stories came to mind after reading an article posted a couple of years ago by Motif. They noted that simple stories drive markets. The article is a good read as they look at investment themes that dominated investing during various periods and how those themes worked out over the longer haul.

You know that adage, “stocks are sold, not bought”? What often drives stocks are simple, plausible stories. In fact, Nobel-winning economist Robert Shiller has made the case for how both financial markets and economies are heavily influenced by stories.

Investors often call these stories their “investment thesis.”  We at Motif like to call them themes, ideas, trends, or motifs. We believe it is far more intuitive for investors to think this way rather than the traditional investment “style boxes” used by mutual funds or risk premium “factors” favored by academics. For example, “small cap value,” which combines academia’s two favorite factors into a mutual fund style box, doesn’t resonate with most investors.

We ask, is your investment story profitable? We might also ask if the current investment story will continue to be profitable or will collapse like a house of cards bringing on another stock market crash, financial crisis, and financial ruin for many. While the Buffett investment story is for long term, buy and hold investors, there are perfectly profitable investment stories for the short term. But, they require that you are able to get in at the right time and get out while the getting is still good.

An example they bring up in the Motif article is the stimulus to the market by ultra-low interest rates in the years following the financial crisis.

For example, the market’s belief in the power of the Fed’s experiments with ultra-low interest rates and quantitative easing (QE) helped drive the S&P 500 much higher from 2010 to 2014, though those policies may ultimately prove disastrous in the long run, as market bears believe.

Right now, no one, including the Fed, knows the long-term impact of these actions.  But much to the chagrin of market bears, until a bear market disaster finally hits, financial markets can and do move significantly higher than one may expect based on pure fundamentals, such as earnings growth, cash flows, price-earnings ratios, credit spreads, and yield curves.

The same to a lesser degree can be said for the Trump tax stimulus which put a lot of money in the hands or corporate America, allowed for repeated stock buybacks, and may well have keep the market up in the last year. A problem with stories is believing in them after they are no longer true or believing in a story when something else is what is driving the market. This is when investors overstay their welcome and not only see their dreams of profits go up in smoke but watch their investment capital go the same way as well!

Is Your Investment Story True?

There is a lot of hype in the markets, especially when a company wants to float an IPO. There are also stories offered by companies that have fallen on hard times and are hoping that they can attract new investors and keep their stock price from falling too drastically. We have written that dividend stocks can be perilous when an investor just looks at the size of the dividend and does not do any fundamental analysis of the company involved. If a company’s stock falls precipitously and they do not change their dividend, investors may be attracted by a 12% or 15% dividend which will disappear in a flash the next quarter as the company “regroups.”

 

When you see Kraft Heinz as a rebound opportunity, is your investment story profitable or are you falling into a value trap?

Kraft Heinz Products

 

An investment story that turns out not to have been as true as we might have liked is Kraft Heinz. This was considered a “widow and orphan” stock, solid with a good dividend. But, these folks have not keep up with changing food tastes and preferences of the American consumer. As such, any attempt at creating a story about this stock in preparation for a recovery are met with skepticism and the suspicious that this stock is now a value trap. Nevertheless, there may be smart enough investors out there who will be able to anticipate when Kraft Heinz has fallen enough to be a good buy again. Then the story needs to be the recovery of a grand old company. Time will tell on this one.

What Will the Boeing Story Be?

We just asked in a recent article, Why Invest in Boeing? We were pretty positive about this company as a long term investment based on their technological expertise and dominance across several areas of aerospace endeavors. But, now there have been two crashes of the new 737 Max 8 jet and both China and Indonesia have ordered these jets to be grounded until the problem can be figured out. It is especially worrisome that some experts are saying that new automated technology designed to make these jets safer may have malfunctioned and caused both planes to crash shortly after takeoff.
Boeing fell 11% on the news and could fall more if these events lead to a general discomfort with Boeing technology. Investors in Boeing will need to decide what they investment story is with the aviation giant and be ready to change that story as events unfold!

 

When you look at Boeing as the perfect investment is your investment story profitable to leading you into long term losses?

Boeing 787 Dreamliner

 

Constantly Re-evaluating Your Investment Story

If your investment story is the same as Warren Buffett’s, you have two tasks to perform. One is to simply keep track of the growth of the American economy and the other is to find and analyze prospective investments. But, if your investment story is the story of the day such as the growth of emerging markets, the migration industrial production out of China and into other Asian economies, or a miraculous resolution of the Brexit mess, this will require constant attention and a good hand at market timing.

A good investment story that lets you sleep at night may be less profitable but a red hot investment story that makes great short term profits may be the stuff of headaches and ulcers.

When Are Cheap Investments the Best Investments?

A couple of years ago we wrote to beware of penny stocks. The point being that cheap investments are not necessarily good investments. After all, there is probably a good reason why a stock is selling for a low price. On the other hand, companies that are just starting out and are not being watched by Wall Street analysts may be very promising but no one is watching. The bottom line for stock value (as opposed to price) is intrinsic stock value. When you have unique insights about the stock in question and the big guys are not watching, you can often make very profitable investments in this area. In this regard we got to thinking, when are cheap investments the best investments?

The Largest Valuation Gap in 70 Years

CNBC writes about the current gap between cheap and expensive stocks. This is called the valuation gap and it is historically large. The last time there was such a difference between the high flyers and the lowest echelons of the stock market was when Harry Truman was President, the world was ravaged from World War II, and the Korean War was brewing.

For investors struggling to find opportunities after a stellar rebound in the aging bull market, value stocks might be the best bet.

Case in point: Cheaply priced stocks are getting cheaper as expensive stocks have gotten extremely pricey, pushing the valuation gap to the widest in 70 years, according to AB Bernstein. The record dispersion puts cheap equities in a sweet spot as other pockets of the market start losing the appeal because of their high prices.

What the analyst emphasizes is that the best time for buying value stocks is the point at which valuations have been spread out the most. Many analysts have commented that this must recent upsurge in the stock market is certainly not being driven by value and fundamentals as earnings are getting worse and growth projections in the USA and abroad are not very positive.

 

When are cheap investments the best investments? It is when the valuation gap looks like it does today.

Stock Market Valuation Gap

 

What CNBC says is from a technical perspective as they look at value stocks as a technical factor. It turns out that when valuations surge to extreme levels, the value stocks whose prices have been left behind tend to outperform in the coming six to twelve months.

Of course, for long term value investors, when fundamental analysis of a stock shows value and the price is low, this becomes a historic buying opportunity.

Unique Investments in Industry “Disruptors”

In this case, we take a look back a couple of years at Trade Desk which was selling for $29 a share after its IPO in September of 2016 and was trading at $49 as recently as May of 2018. Since then the stock has taken off and is pushing $200 a share today. When are cheap investments the best investments in cases like Trade Desk? It is when they change how things are done in an industry or even create entirely new sectors. When this happens it often takes insight more so than analysis of fundamentals to get in when the valuation is still cheap. But, companies like Microsoft and Apple were similar stories back in the day and have routinely offered buying opportunities along the way.

Doing Your Homework on Cheap Investments

Yahoo Finance looks at cheap stocks as well and suggests 7 cheap stocks with potential for price appreciation. They also offer a note of caution about just looking at the cheap part!

Stocks under $5 usually aren’t the best stocks. After all, almost every company prices their initial public offering at $10 per share or more. Thus, if a stock is trading under $5, that means the stock has most likely been subject to a 50%-plus sell-off, which is a sign that the company is having major trouble.

For this reason alone, stocks under $5 should be classified as high-risk stocks by investors.

But, some of them should also be classified as high-reward stocks. Again, stocks under $5 got there because investors sold them in bunches. That means investor sentiment surrounding these stocks is depressed, and expectations are low. If the company can top those low expectations and sentiment dramatically improves, these same really beaten up stocks can become huge overnight winners.

They mention both Snap and Pandora with both doubled in stock price recently. The seven that they offer as buying opportunities are these.

Blue Apron: makes meal kits
Pier 1: Struggling but possibly recovering retailer
Big 5 Sporting Goods: sells sporting goods
Groupon: coupon and savings platform whose demise is not imminent
Francesca’s: woman’s clothing retailer up for acquisition
Blink: charges electronic vehicles
Sirius XM: broadcasting

The arguments for buying these stocks range from “all of the damage has already been done” to “putting their house in order” to “just wait until the need for their services catches up” which is the case for Blink as more and more electronic vehicles are sold.

In each case, investors should be wary and should realize that these stocks are risky propositions. And, in every case, these are not stocks to buy hold and forget about unless you have an investing “death wish!”

Recognizing the Right Value Story

There are times when the stock of a company is falling like a rock and everyone is bailing out, only to discover that the investment makes a huge comeback. One case in point was Sears several years ago. Yes, Sears was the leading retailer, fell behind the times and lost pretty much everything. Even today it is in trouble. But, in the early days of its demise the stock made a huge comeback. This was because investors finally realized how much property Sears owned!

Unencumbered property is generally considered part of a company’s margin of safety. However, in the case of Sears, they were unable to change how they did business, stay ahead of the issue of online sales, and only delayed the inevitable by selling their real estate arm to General Growth in 1995.

Nevertheless, for anyone who looked past Sears as a cheap and dying stock, recognized them as a real estate investment, and then purchased shares, it was a great investment. However, that factor only lasted while it lasted, making Sears a very good investment for a very short time.

 

When Are Cheap Investments the Best Investments? It is when nobody recognizes their hidden value.

Sears Was Briefly a Great Investment

 

When Are Cheap Investments the Best Investments?

The moral to this story is that cheap investments are the best investments when the market is looking elsewhere, when there is overlooked value, and when market enthusiasm drives up valuations into the stratosphere while leaving value stocks behind. Such may be the case today.


Home Privacy Policy Terms Of Use Contact Us Affiliate Disclosure DMCA Earnings Disclaimer