The Common Sense Investor

Normally, you should only buy cheap stocks when you have good reason to think the market is undervaluing the company in the short-term, but have evidence that the company is strong, profitable, healthy and gaining market share.

Everyone wants to save a buck or two. That’s why dollar stores have sprung up across the United States, with cheap goods shipped in mostly from Taiwan and China. A lot of people are taking the easy way to saving money, shopping for small ticket items in these stores. And they get their purchases home to find that they are shoddy, breakable, often unusable.

A bargain is only worth the use you get out of it.

Unfortunately, there are people who apply the same idea to stocks. Penny stocks and junk bonds are about the same thing as items for sale in a dollar store: occasionally you find a gem, but for the most part you get what you’ve paid for: junk.

Moreover, the stocks backed by institutions like mutual funds, banks, insurance companies, and other large-scale investors are the ones that are going to gain the highest growth. They’re also the ones that will increase in price the fastest, which will quickly make them expensive stocks that are not cheap. About 70% of the daily trading volume on the stock exchanges is done by the institutions. That means that the heavy trading – and most of the heavy gains—is in stocks traded by institutions.

Unfortunately, institutions are normally playing “follow the leader” and don’t pay any attention to the low-cost but high value stocks.

The object lesson is that stocks can only be purchased cheap by recognizing two facts. First, over the long term, the market is rational, and stock prices will reflect a company’s value. But second, in the short-term, stock prices may undervalue or overvalue a stock. Finding stocks when they are undervalued is the key. But remember, most of the time stocks are selling for close their real-value (the market tracks real value very well). So, most of the time, stocks are trading close to what they’re worth. This gives you reason to be skeptical of stocks with low P/E ratios. But sometimes, low P/E ratios when combined with strong growth and market share gain, can indicate a buying opportunity.

One strategy you can employ to buy low is to watch which low-cost stocks the institutions buy in large sums. They purchase according to research done by teams, and their choices, while not always right, are consistently good overall. If you can follow institutional trends early enough, you can catch the bandwagon and ride it up.

A lot of advisors will also tell you to look for stocks with a low P/E because these are stocks with room to grow. Well, that’s true, but it’s also true that stocks with a high P/E can grow. The key is to realize that you are paying less of a premium when the P/E is low, so there’s more room for the sotck to move up without becoming irrationaly high. Additionally, stocks with a high P/E are normally high because investors have faith in the businesses growth and earnings potential. An average P/E is about 17. If you can find a stock with a P/E that is less than 17, but which is growing in market share, increasing profits and has a strong Return on Equity (higher than 15), you’ve found a gem.

Another thing you want to be careful of: only swim against the tide if you have really good reason to think the investment is a good one and will make a quick turnaround. This kind of circumstance happens when there is an emotional sell-off but for reasons that will not have long term effects. If a stock is falling because the industrial investors are selling it off, don’t buy it until the price stabilizes down at the bottom; the industrials aren’t going to start buying again until they have better news, and the price will just keep dropping, with 70% of the market either selling it or not buying it.

The low down, then, is to 1) buy cheap stocks (low P/E) only when the industrials are just beginning to buy them or 2) the company looks extremely healthy and you have reason to believe the stock is poised for long-term growth (allow the rationality of the market to prevail in this case) and 3) only buy stocks with falling prices when the volume selling slows down or stops and in cases where you think the stock will go up again. Normally, this happens when there is an excess of emotional selling for reasons that will not have long term effects; the stock will then rebound in the context of a rational market.