Cheap Stocks Can Be Deceiving

One of the unifying traits of investors is that almost everyone wants to find a "cheap" stock to buy. Sure, there are momentum investors and chartists who never pay attention to valuation or price, but the bulk of the investing public wants to feel like it is buying a bargain. What not all investors realize, though, is that not all kinds of "cheap" are equal. The how and why of a stock's cheapness can have major repercussions on portfolio performance.

TUTORIAL: Stock Picking

The Unknown
Many "cheap" stocks are cheap simply because they are virtually unknown. Oftentimes, these are stocks with no analyst coverage. Without that support, nobody with a broad platform is out there to sing the praises of the company. Likewise (and contrary to what investors may believe and what institutional investors and their ad agencies will say), professionals do not necessarily spend their days looking for undiscovered gems and buried treasure.

In fact, many institutions will not even consider investing in a company without a minimum number of analysts covering the stock. Without that institutional support, it can be difficult to produce the necessary buying pressure to move a stock upward.

Unknown stocks can be a godsend for patient value investors; there are often numerous excellent companies out there trading at great prices. On the flip side, it can take a very long time for that value to come to light and it can be a severe trial of an investor's patience. Moreover, some of these stocks also fall into the "unbuyable" bucket, and that can make the wait even longer. (For additional information, take a look at Find Hidden Stock Gems That Analysts Ignore.)

The Unloved
Unloved stocks are those whose companies have sinned against the Street – missed estimates, lowered guidance or otherwise disappointed the analyst and institutional committee. For their transgressions, these stocks are often taken down more in price than the missteps would suggest they should be. Nevertheless, these stocks can continue to trade below their fair value because nobody wants to stick their neck out to support the company – losing money on a popular stock is forgivable, but losing money on a dog (that was a dog at the time of purchase) prompts harsh questions and/or smaller bonuses.

The benefit to shopping amongst the unloved is that these stocks have often been disproportionately punished and have good turnaround potential. Moreover, there is often a period of time attached to this penance and that can give investors a bit more time to sort through and analyze the data. On the other side of the ledger, investors have to be prepared for at least a couple of quarters of skepticism and Wall Street just not "getting it." Moreover, it is important for investors to make sure that the unloved are unfairly unloved – while many companies stumble and recover, sometimes the first stumble is the last warning before the company goes off a cliff.

The Unbuyable
A certain percentage of cheap stocks are cheap because they are effectively off-limits to the institutional community. In addition to some statutory rules for mutual funds, many other professional investors have rules in place that exclude stocks below a certain threshold of volume or market capitalization. In principle, these rules make perfect sense – no fund manager wants to "be the market" for a stock, nor be stuck with a position that takes 10 days to sell.

Just because buying rules make sense, however, does not mean that they do not create inefficiencies in the market. Small investors can often buy these tiny (or thinly-traded) companies and then see institutional interest pick up as the companies grow and expand in volume and market capitalization. In many cases, these are simply family-run (or closely-held) companies that never issued many shares, but are quite content to just quietly go about their business without the attention of Wall Street.

That said, investors still need to approach these names with caution. The stocks of small companies, as well as thinly-traded stocks in general, can be much more volatile than normal and more susceptible to rumors and panic. Investors also need to realize that they may face a punishing bid-ask spread and so limit orders are typically a good idea in this category.

The Misunderstood
A kissing cousin of the unloved, these stocks are cheap simply because the wider investing community does not understand the story. Perhaps a company is saddled with the memory of a bad prior management team or it has changed its business entirely but investors still think of it as being in the "old" business. Whatever the case, the company is not priced or valued on its true merits.

Not surprisingly, these are the stocks that can pay off for investors willing to do the rigorous due diligence. A small edge in knowledge and power can give an investor exceptional leverage without much risk. On the other hand, successfully investing in this category takes a lot of work and a lot of self-confidence. Moreover, investors must be aware of one critical risk – maybe, just maybe, the Street does know the real story and it is the individual investor who misunderstood. (The value of stocks that trade at less than cash per share can be deceiving, see Cheap Stocks Or Value Traps?.)

"Only if Everything Goes Right"
The most dangerous category of "cheap stocks" is that in which stocks only look cheap because of inflated and unrealistic assumptions, estimates and expectations. In point of fact, these stocks are not actually cheap at all; their cheapness is a mirage created by over-excited analysis and analysts.

If there is anything good about this category, it is that momentum can move these stocks from "expensive" to "ridiculously expensive" relatively quickly. Thinking back to the tech bubble around 1999, investors who got into ecommerce, networking and other tech names right before the market went parabolic profited handsomely - assuming that they also remembered to sell.

On the dark side, the valuations of these stocks are built on hype and hope and can collapse very rapidly. Luckily, they are not so hard to spot. If investors see analysts making relative valuation calls - "X is cheap because Y and Z are even more insanely over-valued" - that is a pretty good warning, as are assertions that "it's different this time" or "the skeptics just don't understand." Remember, while a few stocks have traded at 100-times EBITDA and gone on to reward long-term investors, that is not the norm.

Pick the Right Cheap and Get Rich
Hunting for cheap stocks is noble and rewarding work, and a fine avocation for any investor. But like any other hunting, it is critical to know the quarry, its habits, its hide-outs and its hazards. An investor who focuses on the right kinds of cheap for his or her needs and temperament can do well in the market, but it is just as important to avoid the wrong kinds of cheap stocks. (For related reading, take a look at PEG Ratio Nails Down Value Stocks.)

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