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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.





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