Investors who try to buy the top cheap stocks can end up with a loss if they neglect the full picture and focus on just a limited number of investment measures.

When they look for cheap stocks to buy, even Successful Investors sometimes fall into the habit of focusing on those with a particularly attractive reading on a single investment measure. That measure is often a low per-share ratio of price-to-earnings or a low price-to-book-value ratio, or a high dividend yield.

This seems like a quick, easy way of spotting an investment bargain. However, investment measures can span a spectrum that ranges from suspiciously cheap to extraordinarily expensive, so it is particularly important to look closely at these measures.

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Optimism makes more sense when stocks are cheap 

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

But p/e’s by themselves can be misleading. You also need to take interest rates into account. That’s because bonds and stocks compete with each other for investment funds. When interest rates are low, it means the interest income from bonds is also low—so taking that low return into account, low p/e stocks can look even attractive.

Another indication of a top cheap stock can be a high dividend yield. As well, dividends on Canadian stocks qualify for the dividend tax credit. For Canadian investors, this raises the after-tax value of Canadian dividends by about a third, compared to the after-tax value of interest from any source, or foreign dividends (neither of which qualifies for the dividend tax credit).

Four key points for Successful Investors to consider when top cheap stocks are “suspiciously cheap”

1. Many investment measures can span a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
2. To get any real value out of any investment measure, 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.

Seemingly top cheap stocks can harbour hidden risks

Suppose you decide you will only consider buying stocks with a per-share price-to-earnings ratio of 10.0 or less. That way, you hope to get more earnings for each dollar you invest. But the “e” or earnings in the p/e only covers earnings, or an earnings estimate, for a single year. The year your stock’s low p/e looks attractive may coincide with a peak in the company’s earnings, for any number of reasons.

One key reason is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. During this low-p/e period, people close to or involved with the company recognize that it has serious problems. They sell their own holdings and they tell their friends and relations to do the same.

Another common problem is that the company is cyclical and is at the top of its business cycle—and its earnings are at a peak. (It’s easy to overlook the fact that tech stocks tend to be cyclical. Their growth can mask the typical peaks-and-valleys of a business cycle.)

In contrast, specific reasons why a company’s profit may slump for one or more years include the expiration of a patent, new competitors, a rise in costs, adverse legal or regulatory changes, or investigations for illegal activity.

As the saying goes, a low p/e may signal danger rather than a bargain. Note, however, that staying out of high-p/e stocks can also hurt your results.

What characteristics of top cheap stocks do you look for in the market?

What is your experience with “cheap” stocks that turned out to be a money-losing investment?