Will Bargain Stocks Burn You?

For many people, there's no bigger thrill than the one you get from getting a great bargain. But as countless investors have discovered the hard way, just because a stock is temporarily on sale doesn't mean that you ought to put it in your shopping cart.

Dealing with the rally
With the market continuing its advance during the first quarter of 2010, the biggest complaint that many investors have is that the stocks they like have gotten a lot more expensive. Gone are the days when you could buy shares of companies like Boeing (NYSE: BA  ) , eBay (Nasdaq: EBAY  ) , and Microsoft (Nasdaq: MSFT  ) at less than 10 times trailing earnings, as you could this time last year. With the S&P 500 up 70% from last year's lows, the bargain bin is looking pretty empty right now.

That's one reason why investors desperate to buy stocks will inevitably look at the losers from the last quarter. Among Dow stocks, companies such as Coca-Cola (NYSE: KO  ) failed to keep up with the average's overall gains. Inevitable changes in the business models of telecoms like AT&T (NYSE: T  ) and Verizon (NYSE: VZ  ) have many wondering if their days are numbered, but attractive dividend yields and recent dips in their stock prices will tempt value-hunters regardless.

What goes down doesn't always go up
For most value investors, it's only natural to gravitate toward stocks that others are shunning. After all, that attitude definitely helped produce some of the most amazing returns over the past year, as those who could overcome their fears and stomach the prospect of buying beaten-down stocks from the market meltdown profited handsomely in many cases.

But things are a lot different now. Stocks that are losing value are the exception now, and unlike what you saw last year, more of the stocks that have fallen recently have good reasons for doing so. Indiscriminately bottom-feeding on stocks that are hitting new lows is more likely to be your ticket to disaster than a springboard to future profits.

Steering clear of traps
To figure out whether a stock is really a smart value buy, looking at the price is just one element. You also have to compare that share price to the stock's intrinsic value -- understanding that intrinsic values are constantly moving based on changing fundamentals.

As an example, consider natural gas producer Devon Energy (NYSE: DVN  ) . At first glance, its stock may look like a bargain, having fallen 12% during the first quarter. But when you look more closely, you can see that much of those losses stem from a dramatic drop in natural gas prices during the period, which will definitely have an impact on future production and profitability.

Of course, a long-term investor might still see Devon as a reasonable value play, arguing that natural gas prices can't stay below $4 forever. The point, though, is that from a fundamental standpoint, it's entirely possible that Devon's intrinsic value has fallen just as much if not more so than its share price, making it less of a bargain rather than more of one.

Conversely, you'll often run into situations in which a stock with a rising price actually presents more of a value proposition. Whether it's a natural resources company that hits paydirt or a biotech start-up that finds success on its star drug, the true value of a company can change rapidly -- and stock prices will typically follow suit quickly. Staying on top of a company's business prospects takes a lot more work than watching its stock price, but the rewards of identifying causes and disconnects is well worth the effort.

Don't get burned
If you're stuck on the sidelines now wondering how you're ever going to get back into the stock market, try to stay calm. Just as last year wasn't the right time to panic-sell, now isn't the best time to panic-buy shares of anything. If you have money to invest, focus not solely on price but instead on getting the best value for your investing dollars. Even if you pay more for shares than you would have months ago, it could still work out to be a great investment for you over the long haul.

Sometimes your brain seems to be working against you with your investments. Find out why Fool contributor Anand Chokkavelu thinks you might be too smart to be rich.

Scoping out bargains is one of Fool contributor Dan Caplinger's favorite pastimes. He doesn't own shares of the companies mentioned in this article. Coca-Cola and Microsoft are Motley Fool Inside Value picks. eBay is a Motley Fool Stock Advisor recommendation. Coca-Cola is a Motley Fool Income Investor pick. Motley Fool Options has recommended a bull call spread on eBay and a diagonal call position on Microsoft. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy knows good value when it sees it.


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