This article originally appeared on Traders Reserve.
Sometimes cheap stocks are cheap for a reason. However, that is not always the case. There are many companies out there with very low share prices that have solid fundamentals and a whole lot of potential upside. Finding these stocks is no small task, but if you look close enough it is possible to identify cheap stock picks with the potential for a big breakout.
The Virtue of Cheap Stocks
So what are the benefits of owning cheap stocks?
First, we should define what we mean by low priced. Generally, when Wall Street talks about low-priced stocks, it’s talking about stocks trading under ten bucks a share. I actually think this is a bit high. I prefer to define low-priced stocks as those trading under $5 a share, but for general discourse purposes, we’ll use the higher $10 per share marker.
One thing to note is that we are not talking here about penny stocks, which generally are stocks trading under $1. Penny stocks are usually much more speculative than mere low-priced stocks, so be careful not to get low-priced stocks confused with penny stocks.
Perhaps the biggest reason why investors like to buy cheap stocks is because they can pick up a lot of shares for only a little money. If a stocks trades at $3, you can own a round lot (100 shares) for just $300. For $3,000 you can own 1,000 shares. While this seems like a great deal, it’s only a great deal if the shares move higher. In fact, I’d rather own 10 shares of a $300 stock if that stock has the potential to deliver a bigger percentage gain than the $3 stock.
One thing that will be different with that $300 stock versus the $3 stock is that the $300 stock will likely be well known by the public and widely followed by Wall Street analysts. That usually means you aren’t likely to see some kind of huge, unknown upside catalyst that comes out of left field.
That’s not the case with a low-priced $3 stock. In fact, low-priced stocks aren’t widely followed by the big investment research firms, and that means you could unearth a gem of a company before everyone else on Wall Street sees the beauty of its cut, color and clarity.
How to Pick Cheap Stocks
A good rule of thumb is to look at companies with little or no debt; strong revenue and strong earnings growth; a hot product, or a hot industry; and finally, what I call that “little something special.” This something special could be the fact that the company is a potential buyout candidate, or that it has a game-changing product. It also could be a sound company that’s fallen on hard times, but that is undergoing a substantive turnaround.
Basically, what you look for in a high-priced stock is what you should look for in a low-priced stock. The difference is that with the cheap stock, you could see a lot more surprises on the upside. And, of course, you’ll have to be willing to do a lot more digging in your quest to find these little low-priced diamonds in the rough.
For more trades, ideas and strategies, visit Traders Reserve.