Beware The Cheap Stock


Stocks that are trading under 50 cents are always enticing – because you put down a small amount of money for a potentially lucrative return.

However, for many investors, this scenario is just a pipe dream. The fact is that a cheap stock may be cheap for a good reason. Let’s have a look at cheap stocks and the secret pitfalls lurking within.

How to tell if a stock is ‘cheap’

These cheaper stocks can also be categorized by their market capitalisation (that is, the total number of shares multiplied by the share price).

If a company’s market cap is less than $500 million, the company generally is considered a fairly small stock, or a “small cap stock”.

Is bigger better?

Historically, small cap stocks have outperformed large cap stocks.

This isn’t because a lot of small companies are better investments than large companies, but because almost all big companies were small when they first sold stock.

Money-hungry investors turn to small stocks to buy, because these stocks are cheap and it looks like the bigger companies have not much room to grow. Right?

Wrong. Just because a company is cheap and small doesn’t mean it’s going to mushroom in size and become the next CBA.

Beware the cheap hype

Many investors will often flock to internet chat rooms and talk up a cheap stock. This phenomenon is called “pumping and dumping” and it happens all the time.

A stock that maybe trades only 5,000 shares a day is a good example of this type of scam.

As this occurs, an investor might be tempted into buying the stock at an artificially high price and then watch the stock plummet 50% in just a few days.

Once were expensive

Another thing to avoid is a stock that has dropped significantly in price. Just because a stock looks cheap doesn’t meant it’s going to return to glory and you’ll make yourself a big profit.

You have to ask yourself why the stock fell in the first place. What fundamental factors drove the dive? Does it look like this company – or industry – is stuck in a long-term bearish trend?

The fact is that although the market is flooded with stocks that trade below $10, this doesn’t mean the stocks are going to go higher.

In fact, a Merrill Lynch study observing 1,900 stocks that had fallen below $10 a share from 1987-2000 saw that only one out of 30 stocks rebounded to over $15 during the next year.

Those odds aren’t good.

However…

This isn’t to say that all cheap stocks are worthless.

Some small cap stocks are really true movers and shakers, but you have to look at the company and the industry outlook to gauge which way the stock is likely to move.

There are a number of quality small cap stocks, such as those with great growth prospects that have entered into a lucrative long-term industry. Remember, however, that stocks that have crashed significantly usually continue in one direction: down.

Carl Capolingua
Follow Carl on Twitter @CarlCapolingua
Head of Education
Australian Stock Report

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