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Why Searching for Cheap Stocks Is the Wrong Investing Strategy

By Keith Noonan - Updated Jun 3, 2020 at 9:16AM

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Investors should rethink how they formulate value when picking stocks to add to their portfolio.

Every investor wants to find stocks priced at levels that pave the way for capital appreciation. But focusing too intently on stocks that look cheap based on traditional valuation metrics can diminish return potential without meaningfully reducing risk (and even lead to substantial losses). 

Rather than focusing on companies that appear to trade at low valuations, investors will usually be better served by prioritizing companies that have sturdy foundations and avenues to long-term growth. Time and the luxury of patience are the individual investor's greatest advantages in the market, and strict adherence to distinctions between "value stocks" and "growth stocks" can lead to short-term thinking that hinders the pursuit of great deals. 

Stacks of blocks with arrows pointing up and to the right.

Image source: Getty Images.

How do you define "cheap?"

Berkshire Hathaway CEO Warren Buffett famously said that he'd rather own a wonderful company at a fair price than a fair company at a wonderful price. Buffett's incredible track record of stock-picking success is rooted in his understanding that long-term investing tends to create the best results, and this philosophy is at the heart of his oft-quoted bit of wisdom about great companies being superior to "cheap" companies. 

Price can fluctuate substantially over short periods, but value is something that emerges over the long term and is borne out by a business's results. A stock with a price-to-earnings ratio of 100 can prove to be a much better investment than one with a P/E of 10 because value will ultimately be determined by the performance of the underlying company. Stocks that look cheap based solely on P/E, price-to-sales, or price-to-book ratios often trade at low multiples for good reasons.

Companies with cheap stocks often face major headwinds. In some cases, businesses can overcome these challenges and go on to deliver great returns. But companies with beaten-down valuations sometimes face widespread industry declines or other irreversible shifts that make betting on a comeback much riskier than valuation metrics imply. Investors should always be looking for stocks that offer attractive value, but your definition of "cheap" should be calibrated holistically and with the long-term health of the business in mind.

Cast aside the strict dichotomy between "value" and "growth" 

Investors will be better served by seeking companies poised for long-term success than companies that look cheap based on some fundamentals but otherwise face deteriorating prospects. A stock that doubles over the next three years is cheaper than a stock that stays flat across the stretch, regardless of what their respective P/E or P/S values might indicate. In that sense, all investing is "value investing," and stocks that would traditionally fall into the growth category have been delivering superior value for most of the last decade. 

Compare the performance of the tech-heavy Nasdaq Composite Index against the Russell 1000 Value Index over the last five years.

^RLV Chart

^RLV data by YCharts.

It's worth noting that the last half-decade has mostly played host to a strong bull market, but growth stocks have even outperformed value stocks amid bearish catalysts in 2020. Conventional wisdom suggests that value stocks that offer low earnings multiples and big dividend yields would hold up better than growth-dependent tech companies when market conditions become turbulent. But that generally hasn't been the case amid volatile market conditions spurred on by the novel coronavirus.

Through the first five months of 2020, the Russell 1000 Value Index's level fell roughly 16.7%, while the Nasdaq Composite Index climbed roughly 5.8% and the S&P North American Technology Software Index saw its level rise roughly 8.8%. The unprecedented circumstances brought about by the novel coronavirus have benefited many tech companies and accelerated already powerful trends including growth for online retail, digital communications, and cybersecurity services.

No one anticipated that a virus would shape the market's trajectory in 2020, but there were already plenty of appealing growth indicators for these tech trends, and the value and defensive benefits of being positioned to capitalize on them have been evident this year. 

Would you rather own Amazon or Kohl's?

No stock illustrates the folly of rigid distinctions between "value" and "growth" better than Amazon.com (AMZN -0.99%). Amazon has almost always looked very expensive based on most valuation metrics, but investors who bought shares at nearly any time since the company's initial public offering got a great deal as long as they held on to their investment. 

Today, Amazon trades at roughly 122 times the average analyst target for this year's earnings. Meanwhile, struggling brick-and-mortar retail chain Kohl's (KSS 2.98%) has a forward P/E of less than 9.5 and pays a dividend yielding approximately 14.6%. The case could be made that Kohl's is cheaper based on certain metrics, but investors have to consider which company is likely to be thriving five years or a decade from now, and smart money will probably side with the stock backed by dominant online retail and cloud services businesses. 

The waning usefulness of categories like value and growth doesn't mean that investors won't find worthwhile stocks trading at low earnings multiples or offering big dividend yields -- or that valuation metrics don't provide helpful insights. It's always prudent to weigh price against growth potential, but investors should be formulating their stock purchases with the future in mind. More than ever, that means having a big-picture view of companies and outlooks instead of trying to weigh today's prices against yesterday's fundamentals.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Keith Noonan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), short June 2020 $205 calls on Berkshire Hathaway (B shares), short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$139.41 (-0.99%) $-1.39
NASDAQ Composite Index (Price Return) Stock Quote
NASDAQ Composite Index (Price Return)
^IXIC
$12,644.46 (-0.10%) $-13.10
Kohl's Corporation Stock Quote
Kohl's Corporation
KSS
$31.46 (2.98%) $0.91

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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