Before the pandemic, many financial analysts fretted that younger Americans were not investing in the markets to the rate that prior generations did at the same age bracket. A major reason why is that many millennials came of age during a period of tumult and economic recession. That lingering memory had prevented young folks from considering engaging Wall Street, even for so-called cheap stocks.
With the novel coronavirus ravaging the nation – and with Europe’s second wave providing an unwanted harbinger – there is a risk that down the line, future generations of young Americans will also avoid the markets, if not more so. But so far, the pandemic has changed attitudes. Thanks to accessible trading apps like Robinhood, many are diving into cheap stocks.
In principle, it’s not a terrible idea. After all, the common investing adage states to buy low and sell high. What better way to actualize this strategy than to buy cheap stocks? Yet what the “regular” person considers cheap in most contexts (such as buying goods at a store) is different from what an investor looks at.
Indeed, sometimes buying cheap stocks is the worst mistake you can make. A great example of this off the bat is the concept of buying several years old European luxury cars. You may be surprised that you can buy a 2001 Porsche 911 convertible for just under $13,000 (depending on your location). That’s significantly cheaper than a new base model Toyota (NYSE:TM) Corolla.
Yes, that Porsche is indeed affordable, but only at the purchase level. Porsches are notorious money pits. And don’t think I’m picking on this car brand because Maserati is probably the worst offender. So, just because you can technically afford it doesn’t mean you really can or should.
The same idea applies to cheap stocks. Of course, buying a viable company on a discount is everyone’s goal. But if you intend to take this route to the extreme, here are some concepts to keep in mind.
Don’t Buy Cheap Stocks on Price Alone!
It’s worth reiterating that no one should buy cheap stocks simply on the price tag. As many of my InvestorPlace colleagues have mentioned, sometimes the price is cheap for a reason. Usually, it’s for an awfully bad one.
Take for instance the bizarre case of Hertz Global (NYSE:HTZ). When the novel coronavirus transitioned from being a foreign disaster to a domestic one, HTZ stock began crumbling. Although the underlying auto rental center desperately attempted to hold on, it was only wrestling with inevitability. By late May, Hertz declared bankruptcy.
But that didn’t stop some speculators from viewing HTZ stock as an opportunity. After plummeting into literal penny stock territory, Hertz shares began ticking higher. For a few brief sessions in early June, people piled in, driving HTZ to a closing price of $5.53 on June 8.
However, since then, shares have been on a downward climb. Perhaps momentum traders viewed Hertz as one of the best cheap stocks to buy earlier this year, it was trading above $20. But don’t get fooled by price alone because it’s usually a nasty mistress.
Analyze the Industry
The strange story of Hertz Global segues into the next tip regarding filtering out viable cheap stocks from garbage plays: analyze the industry.
Going back again to HTZ, if rookie speculators would have studied the reason why shares fell, they probably wouldn’t have held the bag. Primarily, rental cars are tied to air travel. No air travel meant no demand for these vehicles. Thus, the fact that air passenger volume dropped to below 5% of the year-ago level in April 2020 should have been the red flag for Hertz.
Even the recovery bounce in May averaged less than 10% of May 2019’s passenger volume. There was just no way that this was sustainable for the broader industry.
But this doesn’t mean that you should avoid all cheap stocks with dirt-cheap “paper “prices. For instance, I mentioned in June 2020 that GameStop (NYSE:GME) may have a surprising catalyst. Essentially, you’ve got to look at the industry. GME stock, while deeply embattled, is levered to video games, which saw a tremendous spike during the lockdowns.
Further, if we suffered a steep and prolonged recession, GameStop’s business of secondhand games would be very attractive. It took a while for the narrative to catch up but GME stock is really flying now.
Look at the Fundamentals
Another strategy that will keep you out of trouble is to consider the fundamentals. While I appreciate technical analysis and deploy this methodology whenever I can in my writings, there are attributes that are only apparent when you consider the company’s financial picture.
One of the commonly cited metrics to analyze is the price-earnings ratio, which values a company based on its stock price relative to its earnings per share. Also known as the price multiple or earnings multiple, this gives you a handy way of comparing cheap stocks to other alternatives.
After all, if ABC stock is priced at $10 and XYZ stock is trading hands at $20, does that mean XYZ is twice as valuable as ABC? Not necessarily, as many factors play into the price and EPS components. But by measuring value based on earnings, you can get a better apples-to-apples comparison.
Now, you’ve got to be careful. For one thing, you should try to make PE comparisons of cheap stocks within the same industry. That’s because each sector can have its own “personality,” so to speak. As well, a super low PE ratio doesn’t always mean great value because investors could be factoring in possible lowered earnings.
Nevertheless, it’s always good to check out the PE to make sure you’re not making a mistake. For instance, Delta Air Lines (NYSE:DAL) looks cheap compared to this year’s peak. However, even with the current “discount,” DAL stock is priced at nearly 43-times forward earnings.
That’s probably a deal you don’t want to take considering that airliners have been posting ugly financial results.
Consider the Market’s Emotions
I believe most if not all of my InvestorPlace colleagues will agree with this statement: over time, the fundamentals will always win out. Sure, you can gamble on dumpster fires, but if their underlying industries don’t support an upside narrative, chances are, you’re going to lose money with an extended position.
At the same time, you should consider the irrefutable statement, the market is always right. In other words, sometimes, the fundamentals don’t matter at specific intervals. Therefore, if you’ve got the nerve and a contrarian heart, you may wish to temporarily go against what tried-and-true principles are telling you and in a way, go with the crowd.
Again, this is a very risky tactic. However, you can exploit – if you’re willing to get in and out – the emotions of others. For example, subscription to and involvement in trading apps exploded higher during the early days of the pandemic. As the Wall Street Journal explained, seemingly everyone was now Gordon Gekko.
Understanding this, you could reasonably surmise that rookie mistakes were going to be made. It could be as baffling as green investors not knowing their intended ticker symbols. For instance, Zoom Technologies (OTCMKTS:ZTNO) originally had the ticker “ZOOM.”
Well, you can see the problem when rookie speculators wanted to buy Zoom Video Communications (NASDAQ:ZM). If you recognized the emotions of the market, you could have made a quick buck on ZTNO stock (aka ZOOM) before the Securities and Exchange Commission halted trading.
Politics Can Be a Big Catalyst
Given the vitriol in our political landscape, I understand why people are keeping their own views close to their chest. But that doesn’t mean you should ignore what’s going on with our elected officials. Indeed, by aligning your cheap stocks to buy with the political bickering, you can make the nastiness somewhat more palatable. Allow me to explain.
In my opinion, politics-based speculation is like fantasy football. From what I understand, people get together to form their own leagues and draft individual players (if I’m not mistaken, for defense, entire teams are drafted rather than players). Of course, with the competition, you’re not going to be able to pick exclusively from the team you personally root for (nor would you want to, in many cases).
What you end up with a team of players from multiple organizations that you believe give the best chance at success. Well, it’s the same thing with politics. With a critical election coming up, you should consider buying cheap stocks based on who is likely to win.
Now, I don’t want to discount anybody’s chances. But from where I stand, it seems that former Vice President Joe Biden has the upper hand. In that case, I love firearms companies like Smith & Wesson Brands (NASDAQ:SWBI). Because Biden has gun control advocate Kamala Harris as a running mate, that means Democrats are likely to push for firearms restrictions.
Even if they don’t, the perception that they will should be enough to see SWBI stock jump higher.
Size Up the Competition
Before you consider buying cheap stocks, you should always stack up your target investments with the competition. If the leaders of the underlying sector are having trouble, it’s doubtful that the cheaper and more speculative plays will fare better over the long run.
That’s why I’m interested in American Well (NYSE:AMWL). As a telehealth specialist, its underlining market has extraordinary relevance. During the worst of the coronavirus, many people naturally avoided healthcare facilities. Unless you were dying, you didn’t want to subject yourself to infection risk.
Not only that, science confirmed those fears. According to The Lancet, “Compared with the general community, front-line health-care workers were at increased risk for reporting a positive COVID-19 test.”
More significantly, new coronavirus cases are steadily rising according to the Centers for Disease Control and Prevention. On Oct. 14, the CDC reported nearly 60,000 new infections, which is close to the 74,818 peak case number registered on July 24. I don’t want to speak too soon but it appears that we’re on the cusp of a second wave.
If so, the explosive upside of Teladoc Health (NYSE:TDOC) should provide some confidence to those thinking about betting on AMWL stock. Further, the post-pandemic impact will likely be more pronounced the longer we suffer from the coronavirus pandemic.
As Bocconi University researchers described the 1918 Spanish flu as, “a textbook case of utter failure of health care institutions both in containing the spread of an epidemic and in providing effective care.” As a result, “a climate of general mistrust emerged and, as laid out in their paper, appears to have affected individual behaviours permanently.”
Cynically, that may mean AMWL stock could be very profitable among cheap stocks.
Do the Science
One of the markets where you can find incredibly attractive cheap stocks is in the biotechnology space. That’s always been the case. But with the sudden need to find a vaccine for the novel coronavirus, this sector garnered possibly record-breaking interest.
A company that came up on everyone’s radar is Sorrento Therapeutics (NASDAQ:SRNE). At the time, I thought to myself, what a small world! However, when I drilled into the science behind SRNE stock, I was left with many questions.
If you’re following Sorrento, you’ll know that the company made a hard pivot to Covid-19. In fact, they have everything that you can need for this crisis, including testing, a vaccine and multiple therapeutics. Plus, with management’s bold claims about providing viable solutions, many investors jumped aboard SRNE stock.
However, I’m not sure if these folks checked out the scientific case. If they did, they certainly ignored that Sorrento has made little clinical progress with their solutions. Also, its vaccine will likely require two doses, which doesn’t offer a significant advantage over other vaccines.
I’m not suggesting that SRNE will fail. However, it’s been volatile since I presented my cautionary take. So, if you’re going to bet on cheap stocks in the biotech arena, do your homework. It can make all the difference between huge gains and staggering losses.
On the date of publication, Josh Enomoto held a long position in GME.
A former senior business analyst for Sony Electronics, Josh Enomoto has helped broker major contracts with Fortune Global 500 companies. Over the past several years, he has delivered unique, critical insights for the investment markets, as well as various other industries including legal, construction management, and healthcare.