Why you should not always buy cheap stocks

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Everyone loves a great bargain.

The Great Singapore Sale often causes a rush at the stores as people jostle with one another to lock in big discounts.

The same logic applies to the stock market, too.

When stock prices crash, investors will swoop in with hopes of a bargain in the midst.

This Covid-19 pandemic has led to some blue-chip companies hitting 10-year lows.

At first glance, such stocks will appear as juicy opportunities as the share price is now much lower than it used to be.

However, caution should be advised as a fall in the share price may not automatically make a company more attractive to own.

This is where the stock market differs from shopping at the supermarket.

Here are several reasons why you should not just blindly purchase cheap stocks.

Value traps

It’s important to remember that stocks are often in the bargain bin for a good reason.

The reasons may vary but it can range from having a lousy business model, being in a sunset industry, or facing tremendous headwinds.

As investors, we have to assume that such stocks are often “cheap for a reason”. They may turn out to be value traps.

As such, we need to differentiate which stocks are unjustifiably cheap, and which may constitute value traps.

It’s not an easy exercise, admittedly.

But we can pick up clues and observe red flags to come to an informed conclusion.

First off, look out for any corporate actions or announcements from the company such as a profit warning or a rights issue.

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Such announcements could have resulted in a justifiable plunge in the share price as the act of capital raising indicates it is not business as usual.

Next, we should observe if there have been news reports of competitors muscling into the company’s turf.

Such actions could diminish the competitiveness of the company.

Finally, look out for earnings releases that show how the company is performing financially.

Deterioration in financial or operating metrics will usually trigger a strong sell-off as the company’s value has also declined in tandem.

Altered business models

As Covid-19 has shown, the world can change drastically in a short period.

The speed with which the coronavirus has overtaken the globe has left many stunned.

In just eight months, we have gone from a life of normalcy to one where travel is prohibited, movement is somewhat restricted (in certain countries) and mask-wearing is mandatory.

Businesses had to cope with these rapid and unforeseeable changes.

Many industries, from airlines to hotels, have recorded an unprecedented plunge in revenue as lockdowns and border closures persist.

Right now, no one knows how long these effects will last, or if these industries can ever return to their pre-pandemic state.

The accompanying share price declines of companies within these affected industries is simply a reflection of the uncertainties associated with these radical changes.

You should carefully monitor and study how these effects play out over time.

Don’t be too eager to jump in to scoop up what appear to be bargains until you get a better handle of the overall situation.

Valuation is only a single aspect

Finally, it’s good to remember that share prices, and by extension, valuations, are but one single aspect of a business.

After all, when you purchase an expensive item such as an electrical appliance, you won’t be looking at just its price alone.

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The quality of the item matters, including its durability and ease of use.

The same logic applies to companies, too.

You need to look at various aspects of the business to determine if the cheap price does represent a bargain.

Are gross margins improving? Is the company’s debt level declining? Does the business still generate consistent levels of free cash flow?

And most importantly for income-driven investors, can the company continue to pay out a sustainable dividend?

Asking yourself these questions before taking the plunge ensures you do not buy blindly.

Get Smart: Buy quality, even if it’s not cheap

Back again to the question of whether you should always buy cheap stocks.

The answer, in a nutshell, is…it depends.

If pessimism and poor sentiment have depressed the share price of a company while its fundamentals remain sound, then it makes sense to scoop it to acquire some shares.

But if the business model is flawed, or has seen an irreversible negative change, then perhaps you should step back and observe first.

Alternatively, you can always go for quality, great companies.

Although such businesses are not selling at a discount, it makes sense to pay up if such companies provide great long-term and a good night’s sleep.

This article was first published in The Smart InvestorAll content is displayed for general information purposes only and does not constitute professional financial advice. Disclaimer: Royston Yang does not own shares in any of the companies mentioned.