The Best Cheap Stocks Promise Profit and Growth
This article on best cheap stocks was written by Evan Bleker. Evan is a small investor employing Graham's highest performing value investing strategy, net net stocks. In 2014, Warren Buffett explained that the net nets he bought in the 1960s helped him achieve the highest returns of his career. Evan has used lessons from Warren Buffett, Benjamin Graham, plus other top investors and academic studies to craft a high performance net net stock checklist. Download our net net checklist right now for free. Click Here. Article image (Creative Commons) by William Henry Lewis, edited by Net Net Hunter.
What are the best cheap stocks to invest in? How do you find and analyze these great cheap stocks?
We all love cheap stocks but, paradoxically, the best cheap stocks are both dirt cheap and attached to growing companies.
Most investors make the mistake of assuming that growth investing and value investing are completely different. They segregate them into two separate techniques, forcing themselves to choose between them as their approach to investing. But, as I'll show you below, the best cheap stocks leverage both a dirt cheap price and future growth.
Great Cheap Stocks: Price Matters
No matter what type of value investing methods we use, we can never run away from the key element: price. Price plays an important role in the analysis of stocks, and this is the anchor that determines our returns. Regardless of how fantastic the company may be and no matter what type of analysis you use, the price determines its attractiveness and our call for action.
“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
— Warren Buffett
Great Cheap Stocks: Price vs. Value
Suppose you intend to purchase a new iPhone XS (64GB Gold). You checked the price of this phone on Amazon yesterday, and it was $999. However, when you checked the price today, it has increased to $1,299.
What really happened here? With the change in the price, is there any change in the quality of the phone? Does the phone memory remain at 64GB, or did it follow the price of the phone and increase as well?
The quality remains the same! The only thing that changed is the amount of money you need to pay for the phone. We are getting the same value at different prices.
Putting these into the perspective of the stock market, this applies to the stock prices of companies as well. Although the quality does not change every second, the price does. We have to deal with the fact that price volatility is several orders of magnitude greater than fundamental volatility.
Understanding the difference between price and value is the core principle of investing. We will always fall back on the prices regardless of our investing strategy. The idea is to find the best cheap stocks that are on sale and take advantage of the cheap pricing in order to gain the biggest returns.
“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor — in our view — financially fattening).
“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics — a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield — are in no way inconsistent with a ‘value’ purchase.”
— Warren Buffett
What Makes a Great Cheap Stock Attractive: Value or Growth?
Investors expect growth stocks to grow at a rate significantly above the market average and earn substantial capital gains due to their “privileged” position in the market. Growth stocks tend to have a lot of media attention and high earnings reports. The expectations of higher sales and profits can result in these stocks being overvalued as investors bid for higher prices and bump up the multiples of the company. As growth is its priority, the company will usually reinvest in itself in order to expand. However, if these growth plans do not materialize or if the earnings do not meet the forecasted analyst’s numbers, the price will plummet.
On the other hand, value stocks are often underrated or ignored by the market. These stock prices do not reflect the fundamental worth. They may eventually gain value, but even if the stock does not appreciate, investors typically benefit from dividend payments they receive during the holding period.
Do we buy growth or value stocks? How do we find the best cheap stocks and decide if they are attractive?
“In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.
“We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
— Warren Buffett
However, investors are often attracted to growing companies, regardless of their value and whether it is good or bad growth. How often do you have a hot discussion with a colleague about the up-and-coming latest stock, and the first thing they do is to Google the price charts to look at the growth of the company? They will be willing to pay for these rapid growers at a high price without any hesitation, thinking it will grow perpetually.
Growth stocks tend to share a few common traits. For example, growth companies tend to hold unique product lines, patents or access to technologies that put them ahead of others in their industry. In order to remain competitive and have an edge over their competitors, they reinvest profits to foster newer developments as a way to ensure longer-term growth.
Because of their innovations, they often have a very loyal customer base or a significant amount of market share in their industry. For example, an app development company that is the first to provide a new service may be a growth stock as it gains market share by being the only company that is providing such a service. If other app companies enter the market with their own versions of the service, the company that manages to attract and hold the largest number of users may become a growth stock.
When these rapidly growing companies slow down or do not continue their rapid growth for as long as you expect, shareholders will then re-evaluate the value of the firm and are not willing to pay such a high multiple of earnings. This causes the P/E ratio to shrink and the share price to tumble. Furthermore, you can suffer even larger losses if the stock is purchased at the wrong time.
“Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
“Growth benefits investors only when the business in point can invest at incremental returns that are enticing — in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”
— Warren Buffett
Approaching Value And Growth: Finding The Best Cheap Stocks
Despite the complications, valuing a company within a rational range of accuracy is still a lot easier than trying to predict the future, especially when it comes to growth.
For growth investing approach, we can adopt “The Davis Double Play” strategy, which is a methodology of buying moderately priced stocks that are trading at low P/E multiples and low earnings but are growing moderately fast, yet are neglected by the investing public for whatever reason — perhaps due to their small size. These multiples might then bump to 15 or even 20 with high earnings after they caught the eye of other investors.
We love companies that are under the radar. As deep value investors, we buy great cheap stocks that are trading below liquidation value or asset value — either Net Current Asset Value (NCAV) or Net Tangible Assets (NTA). We can combine “The Davis Double Play” with our deep value investing principles and traditional liquidation value indicators. This provides us with an edge because even when earnings growth slips, the companies that have been purchased are still undervalued based on another conservative metric.
Best Cheap Stocks Strategy: Net Net Growth Stocks
There are three factors — mainly Low Price to Earnings (P/E) ratio, Low Price to Net Current Asset Value (P/NCAV) ratio, and Past and Expected Growth — that we need to consider and factor into our analysis when it comes is finding best cheap stocks. We can use simple metrics to find undervalued companies below liquidation value with solid sustainable growth potential.
Price to Earnings (P/E) ratio:
Price to Earnings (P/E) = Market Value Per Share / Earnings Per Share
The P/E ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). In other words, the P/E ratio tells us how much the market is willing to pay for each dollar of earnings of the company.
Whether a P/E ratio is high or low depends on many factors, including the industry and the stage of growth. Different industries have different norms of what range P/E ratios usually fall into. Using P/E ratios to compare companies in the same industry and business model would be more useful, versus two wildly different stocks.
Generally, a lower P/E ratio is a better buy, since the stock price has not yet risen to the same levels as its peer, all things being equal. Conversely, a high P/E ratio might signal that the stock is currently overpriced compared to its actual earnings and growth potential.
Price to Net Current Asset Value (P/NCAV) ratio:
Net Current Asset Value (NCAV) Per Share = (Current Assets - Current Tax Asset - Total Liabilities - Minority Interest - Preferred Shares - Off-Balance Sheet Liabilities) / (No. Of Shares Outstanding)
Price to Net Current Asset Value (P/NCAV) = (Market Value Per Share) / Net Current Asset Value (NCAV) Per Share
The Price to Net Current Asset Value (P/NCAV) ratio is simply a modified working capital ratio metric that takes into consideration the total liabilities and preferred shares instead of current liabilities. Essentially, this is the company’s liquidation value. The conservative approach is to buy the shares of the company when it is trading below two-thirds of the P/NCAV ratio.
Past and Expected Growth:
We can use the Compound Annual Growth Rate (CAGR) to calculate the company’s rate of returns over the past 10 years. Based on the past growth rates, we can array model for the potential outcomes based on the possibility of occurrences to determine the estimated accurate growth rates annualised over a decade as growth rates will most likely fluctuate year-to-year.
Best Cheap Stock Examples
Twinbird was one of the best growth companies of the mid-2010s and originally bought as a net net stock. Twinbird builds home appliances such as fans, toasters, and space-aged coolers for camping trips. The company has an attractive former level of profitability, price relative to its past four years of earnings, and a sizeable NCAV growth rate. The company had suffered a massive 81% drop in earnings in 2013, causing the share price to tumble.
Despite taking a massive hit to earnings, the company was still profitable and growing its NCAV at roughly 10-15% per year. The crisis had caused the firm’s P/E ratio to sink to almost 7x its TTM earnings, or under 5x its four-year average earnings figure. It also had relatively little interest-bearing debt, at just about 25% of equity, and a Current Ratio above 3x. Summarily, it had a very strong balance sheet. In about four months, the firm’s stock price exceeded its NCAV with a massive 77% gain. That's an annualized return of 308%! Read the full experience here.
Likewise, Creighton’s PLC, a British toiletry manufacturer, was previously a net net stock — trading one-third below liquidation value with a P/E ratio of 4.5x in 2013. The firm had a rock-solid balance sheet and a CEO who owned a large chunk of the company. The company took four years to reach the market P/E ratio of 22.25x, producing a total return of 640%, with an annualized return of 65%!
At Net Net Hunter, you can find a shortlist of eligible net net stocks that fit the criteria and are similar to the examples given above.
Net Net Growth Stocks
Picture this: You find a tiny little tech company with a very strong balance sheet. It’s trading at a steep discount to the net current asset value, but it also has a record of growth — five years of increasing revenue and improving bottom line performance. You look a little closer and see that it’s about to come out with a number of new products that it had spent time developing. Future growth looks solid, and it's only trading at a PE of 5x. This is definitely a screaming buy!
The benefits of combining net net investing strategy with growth to find the best cheap stocks are obvious. Buying a firm with a PE of 5x that’s growing steadily at a 10% will eventually lead to a remarkable revaluation — at a minimum, to an average market P/E.
As investors generally have low expectations and are not counting a lot on future growth, even if earnings growth stumbles, the P/E ratio does not diminish to the same degree. With that, net net investors do not experience the same sort of downside that rapid growth investors face.
Furthermore, it does not take any earnings growth in order for the great cheap stocks to rise in price. Buyouts, liquidations, or a shift in investor sentiments are some of the factors that can aid a company’s stock to reach fair value as well. In fact, if you have bought an entire company, you can just start selling off company assets to recoup the value of your investment.
Therefore, complementing an earnings-based valuation (P/E) and asset-based valuation (P/NCAV) provides an extra layer of safety for us and reduces the probabilities of losing our capital. The best way to invest in great cheap stocks is to look for net net growth stocks.
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