Why Can Cheap Stocks Be Deceiving?

Woman is sitting in huge books, while looking in a telescope

One thing that nearly all investors have in common is the desire to find “cheap” stocks with the hope that they will significantly increase in value — resulting in notable profits. Some investors even focus on “momentum investing” and trade actively based on the volatility trends of specific stocks. In fact, some momentum investors end up neglecting valuation and price completely in order to buy/sell trends. While there are some individuals who are able to successfully utilize this strategy, it is important to know that not all cheap stocks are equal. Moreover, it can be difficult to discern between cheap stocks that are a great deal and stocks that are cheap for a great reason — here are a few tips that might help you out:

Undiscovered Stocks:

There are many stocks that are cheap because they are largely undiscovered by the investing masses. In some cases, these can be hidden gems, but in others, these can be complete traps. Generally, these stocks do not have a relatively significant amount of analyst or media coverage so learning about them can be challenging. As such, it is less likely that the public will be buzzing with praise or criticism. Additionally, undiscovered stocks are much less likely to pick up institutional investors because many institutions will not even think about investing in a stock without a specific (minimum) number of analysts covering it. As result, building buying pressure, which moves a stock’s price upwards, can be especially challenging. Despite these challenges, however, undiscovered stocks can be a blessing for diligent investors. At any given time, there are certainly fantastic companies that are trading for bargain prices — mastering the art of accurate valuation is a major key to unearthing them.

Reliance on Perfect Conditions:

Perhaps the riskiest type of cheap stock is the stock that appears cheap because of inflated and unrealistic expectations or assumptions. Correspondingly, these stocks are often over-marketed as a “cheap buys” and sometimes even the tool of investors who are planning a “pump and dump” scheme. For reference, a pump and dump is when a high net worth investor (or group of investors) “pump” up the price of a stock by buying in large quantity — creating excitement — and then “dump” all their shares once the price meets their desired price. Consequently, you might want to consider being extremely cautious when considering stocks that have picked up a ton of public “hype” in a short amount of time. In such a scenario, proper due diligence is nearly vital to the success of your investment.

Misinterpreted Companies:

These can be viewed as a niche category of stocks. Essentially, they are cheap because the general investing community does not fully understand the company, or its products and services. For instance, it is not completely uncommon for this to happen in the tech sector since so many companies are competing to be on the cutting edge of technology. For these stocks, the best-case scenario happens when the company, and its product/services, become mainstream resulting in the price of their stock rising considerably. On the flip side, there is always the risk that the public never comes to understand the product/services, or the company and its goals are simply not good/profitable. Either way, the idea is that these stocks can present an interesting opportunity and are not valued based on their true merits.

Ultimately, the desire to buy cheap stocks is understandable especially because the potential earnings are so high. That said, it is important to recognize why a specific stock is cheap and determine if there is a legitimate reason to estimate that it is undervalued. Investors who do this well will better their chances of performing strongly in the market, but those who do not might experience substantial losses. As always, one of the biggest keys to success is proper due diligence — independent research is always encouraged!