Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down. -- Warren Buffett
As far as investing strategies go, there are worse practices than buying something for $0.80 and eventually selling it for $1.00. At a basic level, this is the idea underlying the school of finance commonly known as value investing. Backed by plenty of empirical evidence, value investing has been demonstrated time and again as a way to outperform the broader market when applied properly.
It's also what makes cheap stocks today like Apple (AAPL 2.45%), HP Inc. (HPQ 4.01%), and Qualcomm (QCOM 4.17%) examples of the good, the bad, and the ugly that come from buying empirically cheap stocks.
Apologies in advance for the lack of originality, but tech giant Apple remains, in my view, one of the cheapest and most attractive stocks on the market today. Let's briefly review some of the finer points behind Apple's investment thesis.
Trading at 17 times its last 12 months earnings, the Mac maker does not look like a total steal at first glance, although its shares remain far cheaper than the S&P 500 at 26 times earnings. However, after subtracting the $185 billion in net cash on its balance sheet from its market capitalization, Apple's core business can be said to be trading at just 12 times last year's earnings, a discount of more than 50% to the market.
This says nothing of the current-year sales and profit surge one can reasonably expect in the year ahead thanks to the late-2017 launch of the iPhone 8. Thanks to Apple's massive installed base and the fact that it has yet to update the iPhone form factor since the iPhone 6, it seems likely Apple will benefit from a significant iPhone upgrade cycle over the coming 12 months. This only scratches the surface of its longer-term investment thesis, but hopefully, it demonstrates why Apple shares are too cheap to ignore today.
A stock cheaper than Apple, HP shares currently trade hands at 12 times their last 12 months' earnings and 10 times their estimated next 12 months' EPS. However, unlike Apple, HP shares can be seen as being "cheap for a reason" because of the far less attractive economics of its core business.
When the former Hewlett-Packard split into two companies in late 2015, CEO Meg Whitman stayed at the helm of what can be viewed as the "good business," though more recent evidence suggests the opposite. This business trades as Hewlett-Packard Enterprise today and deals with the enterprise IT and server operations of the Silicon Valley icon. After the split, HP Inc. controls the PC and printing operations.
As has been the general trend in the PC business, sales at HP Inc. have gradually declined in recent years. And though the PC will never fully disappear, the sell-side community expects HP Inc.'s sales and profits to remain tepid over the next several years. Seen this way, HP Inc. stock stands as a useful contrast to Apple in that it demonstrates that not all cheap stocks are created equal. More often than not, the market tends to price stocks fairly, and HP Inc. certainly looks like a slow- to no-growth company that is priced as such.
Lastly, I included struggling chipmaker Qualcomm in this list as a cautionary example of a possible pitfall in value investing. As a highly profitable company trading at 16 times current earnings and 11 times forward earnings, it's easy to look at Qualcomm as a company the market simply misunderstands, like Apple. However, Qualcomm could be seen as what the investment community refers to as a "value trap," the very opposite of an attractive value stock.
Qualcomm operates two core businesses. It designs and sells various semiconductors that deal with mobile connectivity, an activity that generates about two-thirds of the company's sales. Because of its important role in developing connectivity technologies like 3G and 4G LTE, Qualcomm's other business collects royalty revenue from nearly every cellular device produced worldwide. This highly profitable activity generated 85% of the company's pre-tax income last year.
However, Qualcomm's patent licensing segment has recently been hit by a raft of antitrust fines and lawsuits from regulators and companies who accuse the company of charging abusive rates for access to its patents. The trend started in China, where Qualcomm eventually agreed to pay a $975 million fine in 2015. Then, late last year, South Korean regulators hit Qualcomm with a $853 million charge on similar grounds. To make matters worse, the U.S. Federal Trade Commission (FTC) also accused Qualcomm of monopolistic practices in January; a similar investigation is underway in the EU. Finally, adding insult to injury, Apple -- a longtime customer of Qualcomm -- actually sued the chipmaker for $1 billion days after its U.S. FTC charges were filed.
Many of these legal issues are still playing out, and Qualcomm has a vested interest in vigorously defending its profit center segment. The sheer volume of the legal pressure facing Qualcomm calls into question the company's entire business model, though, and that's why its shares are so cheaply valued at present.
Hopefully this provided a useful overview of the various types of investing situations one may encounter when sifting through cheap stocks, ranging from diamonds in the rough to highly risky situations. The important thing to remember is that investors always need to dig into the quantitative and qualitative reasons for why a stock is valued a certain way. Value investing can be one of the most consistent strategies to use to beat the market if done skillfully, but not all cheap stocks are created equal.