Great Cheap Stocks: How to Minimize Risk
This article on great cheap stocks was written by Jialin Chua. Jialin is a corporate finance and capital markets consultant in Singapore. She strongly believes in the mantra "price is what you pay, value is what you get," and is always on the lookout for cheap stocks. Her focus is on applying a net net and Acquirer’s Multiple strategy in her personal account. Article image (Creative Commons) by S.Su, edited by Net Net Hunter.
People generally equate the search for great cheap stocks to panning for gold. Investors sift through plenty of junk, hoping to find a glimmer of value that makes all the hard work worthwhile.
As a result, it's easy to believe that investments render higher profits only if the investor is willing to accept a higher probability of losses, associating high risk to high returns. The financial community typically defines this risk as volatility.
But, how much risk are you willing to bear? And how do you determine if the great cheap stocks you’ve spent hours researching are worth the risk?
Is Volatility A Good Measure of Risk?
The common belief is that the higher the volatility, the higher the risk — and over a long period, the higher the return. The amount of variability between highs and lows is measured using the standard deviation of an asset return from its historical mean.
However, manipulating these standard deviation models can be easily done by picking different time periods, since it depends heavily on whether the underlying data is normally distributed. For example, data sets that include the financial crisis, such as the year 2008, will look considerably different from a set of data that starts with 2009 or 2010 instead. Hence, one can skew results towards what you desire to perceive. Volatility gives certain information about the dispersion of returns around the mean, but it also gives equal weight to positive and negative deviations, leaving out extreme risk probabilities.
The model takes into account the fluctuations and correlates these movements to risk. For example, a dollar-valued great cheap stock selling for 50 cents on Day 1, 40 cents on Day 2, and 30 cents on Day 3 will somehow be seen as more risky than a dollar-valued great cheap stock that is selling at 40 cents for three consecutive days even though both stocks are valued at a dollar.
However, the ability to buy the stock at a cheaper price of 30 cents presents an opportunity rather than a risk. If you were buying a dollar coupon, would you rather buy it at 30 cents or 40 cents? Entry at a lower starting point provides greater prospects for capital appreciation, and the risk of an investment is then the probability of an adverse outcome.
Thus, volatility is a very incomplete measurement of risk. Risk is not a number that can simply be calculated. For net net investors, even though volatility does not help in the measurement of risk, it provides ample opportunities to buy net net stocks that are cheaper than usual.
Risks of Great Cheap Stocks
To begin with, net net stocks are generally companies that suffer from larger business problems. There must be some reason for these great cheap stocks to be trading on such a bargain. You concern yourself that these problems will continue to persist and whether it will cause a permanent loss in your portfolio.
Stock prices are usually depressed because people are pessimistic about their future growth; hence, investors have the tendency to avoid them. This causes a drop in volume or a sudden plunge in prices, causing investors to scramble and look for shelter, switching to another investing strategy instead.
Great cheap stocks may be also a falling knife or a value trap. These concerns of net net stocks investing can be counterintuitive, and the fear of losing money can hinder you from making sound decisions. An investor may not have the patience and appetite to wait it out. The paper losses will be too much for one to handle, and this creates panic selling, causing even further losses.
To sum it up, great cheap stocks are typically the ugly and the ignored that you can’t flaunt at parties. Especially now, when we are in the longest bull market in history, the market seemingly sets new highs on a daily basis. It takes a lot of courage to be a contrarian and make decisions that most frown upon.
Looking at net net stocks as a group, it is historically proven that they will outperform the general market over time. This is mainly due to mean reversion; great cheap stocks will rise or fall to meet their intrinsic value over time. The most important measure of risk for a net net investor is the price you are paying for the great cheap stocks in relation to the value you get. Only by buying stocks below their underlying value can you produce an incremental return.
What Your Definition of Risk Should Be
The lower the stock price is relative to the value of the business, the less risky it will be since there is a margin of safety. Hence, net net investors instead should define risk as the likelihood of permanent capital loss and inadequate return. The first thoughts of net net investors when investing in great cheap stocks is not the expected return, but the probability and potential amount of loss of investment. Net net investors believe in protecting their capital first and taking calculated risks to produce high returns.
So … How Do You Minimize Risk?
Net net investors have to avoid overpaying and avoid companies that have declining fundamentals to minimize risk. When you underpay a stock, you reduce the amount of money you will lose if the company performs poorly. If you buy a stock with a shallow discount of only about 1/4 or 1/3, you will be at serious risk of losing money forever the moment the value of the company declines a little.
However, the problem with buying a company that is trading well below that intrinsic value is that the intrinsic value can erode due to weaker financials, causing impairment in your principal investment. Therefore, you have to stack the odds in your favor and minimize your risk as much as possible. The idea is to sieve through all these problematic companies and select those with the largest potential.
Think about a firm that currently trades at a P/E ratio of around 7, giving you a fat yield of 14%! It looks enticing at first glance, but looking deeper into the financials, the firm has a total debt to equity ratio of 90%. The firm is unable to cover its debt, and this puts your principal in danger as the cash flow of the company is at risk. It is much more desirable to look for a net net stock that has a low debt to equity ratio.
Another way to reduce risk is to think about the company's liquidity and its ability to cover short-term obligations. On top of capital markets financing, you can also consider actual business operations financing. The amount of liability a firm assumes is an obligation to a payee that has to be repaid. Liabilities have a negative correlation to the stock value, and this may handicap your principal.
We can dig further into the firm’s financials and understand whether the firm's source of value (in terms of assets, earnings, sales, and cash flow) will erode quickly, remain stable, or grow substantially in the future. If the firm can grow its value over time, then the risk of owning that particular great cheap stock is reduced. However, if the great cheap stock is rapidly losing asset value, it won't be long until that value is wiped out and you lose money. A higher burn rate equates to higher risk. We need to constantly be on the lookout for changes in asset value movements.
In general, you should avoid businesses that are obsolete in nature as they are the most obvious value traps. Examples include companies with primary operations in manufacturing CDs, DVDs, and phone book directories. Companies that have no existing operations have to be avoided as well. A great cheap stock that features a high likelihood of long-run sustainable growth thanks to positive industry environments, macro or demographic trends is an added bonus. This advantage delivers higher returns than firms with comparatively high debt burdens strained by a slow-growing economy.
Further diversifying your portfolio of great cheap stocks can increase your portfolio stability and minimize your risks as well. Diversification ensures risk is distributed evenly and no one single stock can dictate the returns of the portfolio. Investors with a well-diversified portfolio will be able to remove emotion out of their portfolio and will then not be too concerned about day-to-day stock price changes.
Asymmetrical Risk and Reward
Most importantly, net net investors need to strike a balance between risk and reward. It will be ideal to know the company’s financials and operations inside and out and have a deep understanding.
The idea is to protect your capital and maximize your returns at the same time. Net net stock investing strategy is an illustration of both a defensive and high returns potential approach that you can adopt, but it is definitely a long-term strategy. You have to stick by it even with a plunge in your portfolio.
Net net investors who fill their portfolio with positive asymmetric risk-reward great cheap stocks will undoubtedly enjoy comparatively higher returns than the general market — at little or no risk!
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