The good news is that there are ways to purchase low price stocks that will leave more cash in your pocket. This article will discuss how to buy cheap stocks and offer the theory and practical steps.
What is a Cheap Stock?
A cheap stock is a term that means different things to different people. For some, a cheap stock has a share price in the low single digits, like penny stocks under $1. While for others, an affordable stock trades below its intrinsic value through valuation methodologies.
But however you choose to slice it, a reasonable assumption to make about what makes a stock cheap comes down to the expectation of its share price rising in the future. As logical investors, we'd only buy shares in a stock if we believe we will ultimately receive a yield on our investment. This also means that a share can be valued as low as one cent and still not a cheap stock buy if its prospects are bankruptcy.
A problem investors run into when trying to find cheap stocks is that the market tends to price things efficiently and factor in all available information, known as the efficient market hypothesis (EMH). Said differently, a company's share price reflects its current and future prospects.
Whatever thesis you may have about a stock rising in the future has already been considered by others and "priced in" to the stock today, according to this hypothesis. Of course, the market also routinely gets things wrong, which is where the opportunities lay for investors to buy the cheapest stocks.
How to Find Cheap Stocks
"Cheap" means different things to different investors, but in this case, we will assume that the stock has a low share price in the single digits and is trading at a bargain compared to its fundamentals. A "bargain" means that the market understates its value and prospects of the company, primarily through its ability to generate cash flow and after-tax profits.
Although our first assumption should be that the market is pricing a company reasonably, the market is also routinely led by the nose via greed, fear and cognitive biases that distort its accuracy to price companies. Many investors will buy a stock near its overextended peak and sell on the rumors of bad news. Others will selectively filter through a company's filings for reasons to buy and dismiss obvious red flags left by auditors.
While on a more systemic level, once a company becomes a "sure thing, can't lose," investors should panic as the market is no longer pricing the stock efficiently. Challenges in opinion between the bulls and bears allow investors to agree on a fair price through each side evaluating and then reevaluating their positions as an emergent process. But when only bulls or bears talk, confirmation bias seeps in, herd behavior emerges and only one order type is desirable on exchanges. These delusions are sustainable only in the short term and underline why you cannot trust the market absolutely.
Part of finding cheap stocks is looking for a downside catalyst that briefly disconnects a company's share price from its underlying fundamentals. We then take a contrarian approach to what the rest of the market is thinking by performing further due diligence.
Step 1: Monitor the news.
In the stock market, bad news can make for attractive entry points for investors to buy into cheap stocks to buy now. But there needs to be an overreaction by the market of how the event will fundamentally alter the company's ability to generate earnings in the future. An example of this overreaction could be Alphabet's (NASDAQ: GOOG) recent botched unveiling of its Bard chatbot that erased 9% of its share price value, caused by a minor technical error that its competitor product also shares.
It then requires one to be patient and opportunistic and think accurately whether the bad news is in proportion to the share price movement.
Step 2: Assess the sell-off.
Next, we need to contextualize the sell-off in the stock. This step is important as we expect it to be a short-term overreaction. We also want to know how substantially it has disconnected from its fundamentals or if a correction in the stock price was overdue and inevitable anyway. Some of these stocks are already on our cheap stocks buy list, more specifically, our low-priced stocks under $50 page.
Here we want to get a feel for the company's valuation, which you can do through various methods. The easiest would be to compare how the event affected its price-to-earnings (P/E) ratio compared to its long-term average. You can cross-reference this with its historical earnings per share (EPS) ratio. Like most financial metrics, a P/E ratio that suddenly drops below its long-term mean should revert to the average over time. A high EPS may further confirm that the stock is relatively undervalued to its previous levels.
Step 3: Understand the company.
Aside from the company's valuation, other fundamental analysis techniques are applied here too. This includes understanding the growth of the company's earnings and cash flow yield and its outlook, value catalysts, leverage and competitive positioning. Explore the company's specific risks and understand how it fits into your overall portfolio. Reading a research report on the company should give the minimum information required to understand it well enough.
Armed with all this information, we can then ask ourselves why we believe the stock is undervalued and how the market is making a misjudgment of its prospects. Decide to buy and sell after ensuring you don't fall into the trick of confirmation bias. We should also represent the counter-argument of why we could be wrong, and with as much conviction thrown behind it as our argument of being right. Following these steps removes bias, and understanding both sides of an argument allows for critical thinking.
Step 4: Time your entries.
Now, pull up some charts. Using the relative strength index (RSI) and the faster-moving stochastics, we can see if the stock has fallen into oversold territory across different timeframes. We can also see if the stock is trading above or below its long-term moving averages, such as the all-important 200-day SMA.
As a rule of thumb, if the price is below the 200-SMA after the bad news hits, then a lot of momentum has been built over the last six months to return it above this dynamic inflection point.
But we're looking at the charts mainly to discover potential entry zones once the dust has settled. Waiting for a few bars of sideways confirmation lets us know that the hysteria has squeezed out of the price action and that we are getting a good price for our entries.
Step 5: Buy toward the mean.
A couple of things happen reliably after a sell-off caused by bad news. The first is that the stock price dips into oversold territory, with sellers becoming tired through the rapid offloading of shares. Once the sellers are exhausted, they stop selling, and buyers briefly take over, creating a price floor that prevents prices from falling lower. However, the downside momentum is still strong from the sell-off, so shares will bounce from the support formed by buyers, followed by a few bars of indecision around if this support will hold or crumble. Doji candlesticks and their tall-wicked cousins are typical here before momentum finally changes to the upside.
After momentum changes, here is when we want to unload our payload of buy orders as the price reverts toward its long-term mean. The Bollinger Bands indicator will show the long-term mean price before the sell-off and how many standard deviations you are getting on your money from the average.
Fire your orders hard and fast — indecision and strategies such as dollar-cost averaging will cost you money here, as the cheapest entries you may get soon are the ones you see right now.
Is There a Downside to Investing in Cheap Stocks?
Yes. As a rule of thumb, cheaper stocks are worth less than expensive ones because the market assesses them as having worse prospects. This is why a high P/E can indicate that a stock has quality earnings, while low P/E stocks can be considered dubious. People generally get what they pay for, and these are only sometimes the best examples of stocks on sale to purchase.
A key to understanding why cheaper stocks are priced the way they are comes from the discounted cash flow (DCF) valuation model. This model seeks to assign an absolute dollar value to a stock today based on projected earnings and other assumptions that will unfold starting from years in the future into perpetuity. Wall Street relies on the model as it loosely tells us how much cash a business could provide investors, with free cash flow being the company's concrete, intrinsic value.
Therefore, a company's stock price reflects a series of assumptions and projections about its future cash-generation potential and not just its ability to produce cash today.
Cheap Stocks: Not Always What They Seem
Rational investors should start with the assumption that the market is right most of the time. If you spot what might be a cheap stock, it's probably not the bargain you think it is. Most stocks have potential upsides already priced in through market efficiency, and future cash flows are discounted to their net present values.
In saying that, the market is not omniscient or perfectly efficient and falls to the same human foibles of individual investors. Elements of greed, fear, groupthink and overconfidence often show up. These elements may cause temporary mispricings of stocks and thus provide valuable long and short entries for both day traders and long-term investors.
Here are some frequently asked questions answered on how to buy cheap stocks.
How do beginners buy stocks?
Before investing, beginners should fully grasp fundamental and technical analysis, economics and business theory. It's also important to understand the risks and that investing in a low-cost index fund is far safer than picking individual stocks. To get started, choosing a reliable broker is required. You can also look at our page on stocks under $20 for investment ideas.
Can I buy stocks for $5?
Yes. You can buy stocks at all price levels, including for $5 or less. This price level and below is where the universe of penny stocks resides, which offers as much upside as potential losses. Some penny stocks are also riskier than others, with some of the most volatile in biotechnology and tech startups.
Can I buy stocks for $1?
Yes. You can buy stocks under 50 cents or lower, so it's possible to pick up stocks for $1. These companies are worth less than lottery tickets, and evaluating their potential is about as likely as choosing the winning lottery numbers. Younger investors can afford to gamble with these to hit a moonshot accidentally.