Legendary investor Warren Buffett said, "It's better to buy a wonderful company at a fair price than a fair company at a wonderful price." You can read that to mean Buffett isn't buying cheap stocks, and you shouldn't either.
Low-priced stocks have their appeal, for sure. An ultra-low share price or P/E ratio inspires your inner bargain hunter -- that's the part of you that'll buy a 101 ounces of green beans from Sam's Club, simply because the per-ounce price is phenomenal. Plus, since single shares of Amazon.com (NASDAQ:AMZN) are trading at $2,500-plus for a P/E ratio of 120, you might feel like cheap is all you can afford. But there are several reasons why bargain stocks shouldn't be the core of your portfolio. Here are three of them.
1. Cheap can mean low quality
A low P/E ratio doesn't always mean the company is undervalued. It can also mean the investment community isn't optimistic about that company's future earnings potential. That's why it's important to look beyond a low P/E ratio, or a low share price for that matter, to understand what's driving the low number.
Either you've uncovered a true diamond in the rough that other investors are overlooking, or the company has underlying issues that have a good chance of stunting its growth. Younger, smaller companies might have limited access to financial resources, a questionable business model, or an unknown management team. Older, more established companies might be facing tough competition from start-ups or be saddled with high debt balances. In those situations, the bargain price tag may not be worth the trade-off.
2. Potentially lower trading volume
If the investment community doesn't value a particular position, trading volume is naturally lower. And low trading volume is problematic for two reasons. One, it's associated with high price volatility. When fewer orders are placed, a large shareholder can sway the share price with a single transaction. This problem plagues penny stocks and investors with smaller positions end up losing out. And two, low trading volume creates a liquidity problem for you. When there's a smaller pool of investors interested in a stock, it's harder to sell.
3. Higher price volatility
Use a stock screener to view the stocks with the most price volatility in a given timeframe and you'll typically see that ultra-cheap stocks with no P/E ratio dominate the list. Volatility can be an advantage if you're a savvy swing- or day-trader, but most investors are better off avoiding companies with extreme price volatility.
Volatile stocks are riskier because the demand for those shares is unstable. You can lose a lot, very quickly. But volatile stocks are also high maintenance; they're not well-suited for part-time investors, because you have to stay attuned to company and industry news and be ready to change your strategy, fast.
What to do instead
Rather than seeking out bargains, look to invest in quality. Building your portfolio around solid companies with strong track records isn't the sexiest approach, but it is the most reliable. Companies with proven management teams, access to capital, and a history of keeping pace with market trends can often sit in your portfolio for years and years, paying you dividends and growing in value. You won't have to worry constantly about when to buy or sell and -- importantly -- you won't risk losing all of your investment in a single trading day.
And don't let high share prices or even high P/E ratios scare you off this strategy. You can make low-dollar investments in quality via mutual funds, exchange-traded funds (ETFs), and index funds. Or, if your brokerage allows it, try fractional investing. That's the practice of buying shares in units of less than one, for a fraction of the full share price.
Look for quality first
Bargain hunting in the stock market may feel like a good idea, but it's a hard way to make a buck. Remember what Buffett says and shift your focus to quality at a fair price.