Five Investing Pitfalls: #2 Buying “Cheap” Stocks

I wish I had a dime for every time in the last month I’ve heard a market commentator argue that a beaten-down stock is a buy solely because it is “cheap.” Maybe with all that money, I could pay investors back for all the money they’ve lost buying these supposedly bargain stocks.

At a recent visit to a bookstore, one of the financial publications was touting Wachovia (WB) as a buy at 40. The logic was basically “the stock has gone down a lot already, the PE is only 9, and it pays a 6% dividend while you wait for it to go up.” This might make sense if:
1) The stock hadn’t gone down for a good reason (write-offs, and an uncertain credit and banking market) and
2) Future earnings and dividends are guaranteed (many on Wall Street worry that WB may cut its dividend and earnings forecasts like other banks)

But the magazine didn’t mention these caveats, nor even attempt to give any catalyst for upside to the stock aside from the fact that it was “cheap.” Well apparently the market didn’t think so, and the stock is down another 20% in a matter of weeks.

While WB may yet end up being a long-term buy at 40, the reason is not because it was “cheap”. Rather, its business or the overall economy will have improved. With financial stocks in the toilet and nearly everyone jumping on the recession bandwagon, this is not the time to buy something without strong conviction. Investing 101 dictates that no matter how bad things may seem, they can always get worse.

Why try to guess the bottom instead of waiting for at least a modicum of evidence that things are turning around? Ask the Caylon Securities analyst who kept a “Buy” rating on Capital One (COF) despite its recent earnings warning (he’s had a buy rating on the stock since $80!). “I think it’s dead money for a while. I think that if you bought this stock at $40, in two years, you’d be happy if you did.” And yet he still recommends buying it now? Personally, “dead money” didn’t make my list of top investments for 2008.

Similarly, shorting a stock simply because it appears expensive can be a similar exercise in futility. Just look at the run of Salesforce.com (CRM), which looks pricey by almost any metric. And it’s been practically a daily ritual for someone on Seeking Alpha or another investing site to call the top on white-hot solar stocks like First Solar (FSLR). As you can see by the chart, it’s a dangerous exercise trying to get in front of the hype train.

As evidenced by our success in shorting Build-A-Bear Workshops (BBW), sometimes shorting “cheap” stocks can be the most lucrative. Wall Street is no different from any other market- too often you get exactly what you pay for.

At SmartGuyStocks we hate leaving money on the table. Too often, popular beliefs about investing lead to that result. We have identified five common mistakes that investors make. Stay tuned for the next three installments of “SGS Five Investment Pitfalls.”

See: Five Investing Pitfalls: #1 Long-Only