Many of the cheapest stocks are so affordable because they are failing

All investments come with a mix of risk and potential reward. The greatest danger comes when you understand the mechanics of an investment, but you’re missing some of the details. Your understanding of the potential reward can make you greedy, while the gaps in your knowledge limit your natural, healthy sense of skepticism.

It’s important to realize that the cheapest stocks are not necessarily value stocks.

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When you buy the cheapest stocks, they may be worth only what you pay—you can’t negotiate a favourable purchase price

Investors who “bargain shop” for stocks explain that they are simply looking to buy stocks like a smart consumer would buy a car. But they overlook one key difference. Car prices do vary, and some buyers do pay less than others, because they have better bargaining skills and more time to spend shopping around.

However, the stock market is more efficient than the car market, as an economist would put it. You can’t negotiate a favourable price for a stock. To get a lower price, you have to wait for the stock’s price to come down.

Aim for a deal when you buy the cheapest stocks and be left open to a double risk

Two-part investing exposes you to a double risk. Seemingly attractive stocks can drop for months, or even years, before a hidden flaw comes to the surface and explains their weakness.

For that matter, little-noticed stocks sometimes rise for months before the reason for their strength becomes apparent. In a lifetime of investing, you’ll choose both kinds of stocks.

If you always try to buy below the market, you’ll always get a “fill” on stocks with hidden flaws. They’ll always come down into your buying range ….and they’ll keep on falling.

But you’ll never get to buy the other kind of stock—the kind that keeps going up. These stocks will always seem too expensive, and they’ll go on to get even more expensive. But you need a few of these ever-more expensive stocks to offset the losses from those that get cheaper and cheaper.

There’s no easy answer to the buy-now-or-wait dilemma. At times it may pay to hold off—for instance, a company’s stock will often rise when it announces a stock split, then fall after the split takes effect.

In the end, if a stock is truly worth investing in, you should be willing to buy it at current prices, even if that means you run the risk of having to sit through a 5% to 10% setback. Before it slips into its next 5% to 10% setback, after all, it may first go up 50% to 100%.

Finding value stocks instead of the cheapest stocks

Finding top value stocks is among the most profitable strategies of successful investing.

High-quality value stocks are reasonably-priced stocks, if not cheap, in relation to their sales, earnings or assets. Investors hold onto them because they expect that other investors will recognize their value and push up the share price.

High-quality value stocks like these are difficult to find, even when the markets are down. But when you know what stocks to look for, you can discover them.

Identify these safety and financial factors as part of a value investing strategy

• 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.
• Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, don’t have that power.
• Geographical diversification. Canada-wide is good, multinational better. There’s extra risk in firms confined to one geographical area.
• Manageable debt. When bad times hit, debt-heavy companies go broke first.
• Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.

Have you ever sought out the cheapest stocks? How did they perform for you? Share your experience with us in the comments.