These key tips will help you spot the best cheap stocks to buy for your portfolio—and avoid the bad ones

It pays for Successful Investors to take an optimistic view of the best cheap stocks when prices appear low—for instance, when stock prices are in the middle or low end of their long-term range, based on p/e ratios.

However, it’s key that you dig deep to determine if the stock really does offer value—or if it is cheap due to hidden problems.

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Consider these four key points when what look like the best cheap stocks are “suspiciously cheap”

1. Many investment measures or ratios can span a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
2. To get any real value out of any investment metric, p/e’s included, you need to look at them in the context of everything else that’s going on in the market and in individual stocks.
3. Most investors, most of the time, will find their best opportunities in the middle of the spectrum, far from the extremes of suspiciously cheap to extraordinarily expensive.
4. It’s a mistake to focus on stocks in the “suspiciously cheap” end of the p/e spectrum. It’s also a mistake to reject stocks out of hand, just because their high p/e’s make them seem too expensive.

Remember that penny stocks are rarely examples of the best cheap stocks to buy—the risks typically outweigh the potential gains

Investing in penny stocks—which generally trade for under five dollars a share, and as the name implies, sometimes for pennies—is one way to buy cheap stocks. But you need to be very careful. Penny stocks do sometimes pay off, but there are many pitfalls to avoid. You should be aware that many penny stocks are little more than very well executed marketing campaigns. Penny stock promoters will do anything in their power to get their penny stock noticed, including TV interviews, podcasts, newsletters and other paid sponsorships.

If you lose money in speculative pennies or other low-quality stocks, you may think your main mistake was bad timing. That’s a misconception. All penny stocks rely on luck to become wildly profitable.

Buying low-quality penny stocks is one of those things that can appear to be successful before it goes badly wrong. Some get hooked on it, since low-quality stocks can be highly profitable over short periods. That’s because they are generally more volatile than high-quality stocks.

In penny stocks, as with games of chance, the odds are against you.

For the best ‘cheap’ stocks to add to your portfolio look for true value stocks

Stock bargain hunting doesn’t always mean penny stocks. Many investors seek out “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to their sales, earnings or assets). One of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” and then hold on to them as mainstream investors recognize the value and push up the share price.

These bargain stocks will trade lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many new tech stocks, for instance, start out as growth stocks and transition into value stocks. They have low price-to-earnings and price-to-book ratios—which is why they’re less expensive than growth stocks. Due to this fundamental distinction, a value stock is often traded at a more affordable price than a growth stock.

Look for these financial factors to find the best cheap stocks:

• 5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
• 5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
• Manageable debt. When bad times hit, debt-heavy companies often go broke first.

Take advantage of the four financial ratios we use to spot bargain stocks to investigate

When you’re looking for undervalued stock picks, as a first step it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

High-quality undervalued stock picks like these are rare and hard to find, even when the markets are down. But when you know what to look for, you can discover them. These are four of the financial ratios we use as a guide to spotting undervalued stock picks:

1. Price-earnings ratios
2. Price-to-book-value ratios
3. Debt to equity ratios
4. Price-cash flow ratios

Use our three-part Successful Investor approach to help spot the best cheap stocks to buy for your overall portfolio

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Have you ever bought a cheap stock and sold it right before it dropped? What led you to that decision?

What do you look for in cheap stocks to add to your portfolio and limit your risk?