Cheap Stocks: Separating the Deals From the Duds

Blindly buying stocks on clearance can be hazardous to your portfolio.

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Despite the market's roaring rally over the past three months, some stocks—including those of well-known companies—still look cheap. Stocks that recently traded under $15 include Sun Microsystems, General Electric, and Pfizer; not surprisingly, shares of Citigroup, General Motors, and AIG can be had for less than $5. But as many investors learned in 2008, a low share price doesn't always indicate a bargain. Often, when a company's shares have fallen off a cliff, so have its earnings. "There are two kinds of cheap when it comes to stocks: those that deserve to be cheap and those that don't," says Bob Auer, senior portfolio manager of the Auer Growth fund. "Just because Citi used to be $30 and is now $4 doesn't mean it's a good deal. General Motors, Ford . . . they're zombie stocks—the walking dead—but we haven't killed them off yet. I wouldn't touch these."

So how do you separate the deals from the duds? If you don't have the time or the know-how required for individual stock investing, it's better to leave it to a professional or put faith in an index. (Here are 4 less risky ways to invest in the stock market and 6 mutual funds for the long haul.) But if you'd rather be the stock picker, get ready to do some digging—through annual reports and 10Qs (quarterly updates companies are required to file). Here are a few tips on how to evaluate stocks, including things to look out for:

Understand why the stock is cheap. Some cheap stocks are actually value traps, which "look cheap, but they aren't really because something is fundamentally wrong with the company," says Tim Hanson, a senior analyst at the Motley Fool. "These stocks could go down further or won't outperform the market and generally end up being disappointing." Not only should you look beyond a company's current share price; you should look beyond its past performance, especially in the short term. For example, a lot of companies shot out the lights in 2005, 2006, and 2007, Hanson says, but they were also buoyed by a strong economy. "You might be wowed that a stock grew 20 percent or 25 percent and think it'll get back there in 2010 or 2011," he says. "But the company might be a natural grower at 8 percent. You can get blindsided if you don't look further back." Share prices are a fine place to start, but balance sheets—which you'll find within each quarterly report—will give you a better picture of a company's health and growth prospects. The challenge, of course, is learning how to read balance sheets. Here's a quick primer from the SEC.

[See Penny-Pinching Strategies for Investing Cheapskates.]

A word on quality . In shaky markets like this, quality rules. That means companies with airtight balance sheets, smart managers, and plenty of cash on hand. Larry Coats, a manager of the Oak Value fund, says he's looking for businesses that have "a superior position from a competitive standpoint, a superior structure in the way they operate, and no significant debt." He continues: "There's nothing wrong with buying cheap, but if you buy a lousy business at a cheap price, you've only got one way to be right—and that's that the stock's cheap." A good way to get a glimpse of the company's operations—as well as its management in action—is by listening to its quarterly earnings call (check the "investor section" of its website to find out when the next call will take place). This teleconference, which is usually broadcast live several hours after the earnings announcement, is your chance to eavesdrop on company bigwigs discussing the quarter's financial results and filling in details not included in the earnings release. Sometimes, individual investors can call in and ask questions at the end. If you miss the whole thing, you can find full transcripts of the calls at Seeking Alpha.

Cash versus debt . Banks are tightening lending these days, which could lead to cash shortages for companies that are overly leveraged. Investors should look at how much cash a company has on hand (listed under "current assets" on the balance sheet) versus how much debt is on the books (listed under "liabilities"). Generally, you want to see that assets are greater than liabilities by a fair amount. "Subtract assets from liabilities, and you get net worth—just like if you subtract your debt from what you have in checking, savings, and so on," says Auer. But there's more, he adds: "There are current assets and others. Current assets are easy to add up: that's your checking, savings, CDs, and what's in your wallet. 'Others' is open to interpretation—saying your condo is worth $230,000, for example. You want a company that has a lot of assets under current assets."