What is a cheap stock?

When the market falls heavily like it has over the past few weeks, there are two common reason investors want to get into stocks.

The first is their emotions. Many investors are controlled by the fear of missing out, although in the current market conditions, it would be wise to be patient. The second reason investors want to buy in, is because they believe stocks are cheap given how far they have fallen.

But what is a cheap stock?

Cheap implies that you will get a bargain, which may be the case when you go to the supermarket, but it is not the best mindset or strategy to adopt when investing in the stock market, as it can cost you a lot of money

Many people buy stocks because they perceive them as cheap, but exactly what do they mean by cheap?

Is a stock that is falling in value cheap? Maybe, provided it doesn’t continue to fall once you purchase it. Is a stock trading under $5 cheap? Maybe, but you have to ask cheap in comparison to what? Is a stock that is trading under $1 good value? Possibly, although many of these stocks are referred to as “penny dreadful” stocks and for good reason.

While it is easy to compare two items at the supermarket to determine whether you are getting a bargain, you cannot do the same when it comes to comparing stocks, as price alone does not imply that it is cheap or expensive. A stock is only cheap or expensive in comparison to the real value of the asset, not just the price of the share at any one point in time.

I have lost count of the number of people who have told me they invested in a stock because it was cheap. When I ask why, they tell me they can buy more shares in a stock that is trading at $0.50 than they could buy if a stock was trading at $20. But it’s important to understand that the amount of shares you own is irrelevant to your potential profit.

Let me explain.

If I have $1,000 to invest, I can purchase 2000 shares at $0.50 or 50 shares at $20. If the shares rise by 10 per cent, do I make more money on the $1,000 invested in the $0.50 shares compared to the $20 shares. The result is exactly the same, although it is highly likely that a $20 blue chip stock has more potential to rise by 10 per cent than the $0.50 stock, and is far less likely to fall heavily in price.

While there is always the temptation to buy shares that have fallen heavily, I would caution you against doing this because in my experience, when investors buy cheap stocks trying to get a “good buy”, they usually end up saying “goodbye” to their money.

So now is not the time to be buying and contrary to what you may be thinking, there will be plenty of time to profit once the market confirms it has stopped falling.

So what are the best and worst performing sectors this week?

With so much going on over the past few weeks, it has felt like time has moved much slower than normal. I know I have said in the past that a week can be a long time in the stock market especially, given that last week everything was falling heavily. Yet, this week has been the opposite.

Industrials is leading the way up over 12 per cent, followed by Healthcare and Information Technology, both of which are up over 11 per cent so far this week. Currently, only two sectors are in the red with Consumer Staples down just over 1 per cent, while Utilities is down just under 1 per cent. Consumer Services is also near the bottom of the list up over 2 per cent.

Looking at the ASX top 100 stocks, we would normally be quite happy to see stocks up a few per cent on the previous week yet as of writing, over 25 per cent of the top 100 stocks have risen more than 10 per cent for the week.

Surprisingly, Qantas is leading the charge up over 37 per cent, while Sydney Airport is up over 25 per cent and Santos is up over 24 per cent so far this week. It is not as bad as previous weeks for the worst performers given that only the Bank of Queensland has fallen over 10 per this week while Flight Centre has been in a trading halt. Vicinity Centres and JB Hifi were also both down over 6 per cent.

So what's next for the Australian share market?

On Monday the stock market fell to 4429.12 points making the current crash 22 days long and the fall 39 per cent from the high on 20 February. From the open on Monday of this week, the market is currently trading around 6 per cent higher after three days of sustained rises, and investors are now asking if we have seen the bottom. Remember, it is normal for the market to bounce and retest prior highs and last week I mentioned that we should see this occur any day now and to last over one or more weeks.

It is foolhardy to jump into a volatile market that has only risen for a few days after falling so heavily; in fact, it is very dangerous. Right now, investors need to be patient as there will be plenty of time to buy into good stocks. What is likely to unfold is that we will see a short rise over the next one to four weeks before the market falls away to test the prior low.

While nothing is certain, it is dangerous over the next month to attempt to bottom pick perceived cheap stocks trying to grab a bargain.

Dale Gillham is Chief Analyst at Wealth Within and international bestselling author of How to Beat the Managed Funds by 20%. He is also the author of Accelerate Your Wealth—It’s Your Money, Your Choice, which is available in bookstores and online at www.wealthwithin.com.au