Should you buy “cheap” stocks?

Should you buy “cheap” stocks?

This content is for information and inspiration purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult an independent financial adviser.

Most of us enjoy the feeling of finding a bargain, especially for something we hold in high value (e.g. an antique). In the investing world, value investing describes the strategy of finding stocks (publicly-traded companies) which appear to offer prices below their “fair value”. The UK stock market in 2022, for instance, is widely regarded as “cheap” or “undervalued” by analysts, which leads some investors to be highly attracted to it. Yet are certain stocks cheap for good cause, and should they be sought after or avoided? 

In this article, we explore different ways to identify “cheap” investments, some alternative strategies to value investing and how they compare as potential routes to building long-term wealth. We hope this is helpful to you. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:

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What are “cheap” stocks?

Cheap or undervalued stocks are those which seem to be trading below a fair estimate of their value. A range of measures and methods can be used to determine whether a stock is trading at this level. For instance, the price-to-earnings ratio (P/E ratio) looks at current earnings (per company share) in relation to the current share price. If the P/E ratio for a company is “high” (e.g. compared to other companies in its sector), then investors may widely believe that it has strong growth potential and so are willing to pay a premium for it. 

Different P/E ratios can be combined to produce an average for a specific sector or entire market. The S&P 500, for instance, has historically had a P/E ratio of between 13 and 15. At present, it stands at around 19; down from 22.89 in the first quarter of 2022. However, the P/E ratio does not always work effectively. Earnings per share (EPS) can miss a lot of detail about the performance of a company and glosses over structural considerations, such as debt.


Value investing versus other options

There are at least two other investment strategies for building a portfolio. The first is momentum investing, which involves looking at market trends and finding and buying assets (e.g. stocks) which are rising in price and them selling them at/before their peak. The second is growth investing, which focuses on buying companies which are expected to outperform the market over a long period. These companies may be younger, tech-based businesses which do not have a lot of competition and which have a sustainable competitive advantage. Typically, the profits are not distributed to shareholders (as dividends) but, instead, are ploughed back into growing the business and its share price. 


Choosing an investment strategy

It is difficult to definitively say which investment strategy is the “best”. Indeed, each one has distinct strengths and weaknesses, which each performing better or worse depending on the time (and place) in question. Since the 2008-9 Financial Crisis, for instance, the FAANG stocks in the USA (Facebook (now Meta), Amazon, Apple, Netflix, and Google (now Alphabet)) have performed remarkably well and have driven much of the nation’s stock market growth. However, looking at longer periods of time, there is evidence to suggest that “value stocks” perform better in the USA – especially during bear markets and economic recessions. This might be because investors are willing to take fewer risks during periods of uncertainty and so “retreat” to those companies with strong existing cash flows, profits and financial buffers.

Momentum investing can be effective for investors with the time, inclination and knowledge. Yet, given the research required to identify trends, “ride them” to their peak and then rebalance the portfolio regularly, it will likely be too labour-intensive for many investors. One way to “delegate” this work is to invest in actively-managed funds which follow a momentum strategy on investors’ behalf. Here, fund costs can be higher compared to others (e.g. tracker funds) to employ the team behind it. Investors will need to carefully consider whether the potential returns justify this possible extra cost. Value investing can also often involve choosing actively-mananged funds, since fund managers may need to sift through different stocks in a market and pick out those for the fund which are deemed “fair value” (or undervalued). However, this may not be necessary if an investor simply wishes to buy a fund which invests in a largely undervalued market – such as the FTSE 100 in the UK.

To some degree, choosing an investment strategy rests upon an investors preferences, goals, interests and personal philosophy. Regardless of your approach, however, it is wise to consider sticking to your strategy over the long-term once it is selected. Constantly switching between different approaches is likely to result in excessive buying and seling in your portfolio, which can lead to crystallised losses and long-term underperformance. Speak with a financial adviser if you want to explore your investment options in more detail and arrive at an approach which fits your goals and needs.



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