If You Want To Buy Cheap Stocks, You Should Know These 2 Things

Credit: Simon Cunningham

Buying stocks when they have low valuations helps stacks the odds of success in our favour. That’s a very important concept on how the stock market works that many investors know.

But, there are also crucial things about this aspect of the market that not many investors may know of.

First, buying a stock with a low valuation does not mean that you’d be immune from any short-term declines.

The well-known oil & gas and utilities conglomerate Sembcorp Industries Limited (SGX: U96) provides a great example.

At the start of 2014, the company had a share price of S$5.49 and a price-to-earnings (PE) ratio of just 12. That’s low. For perspective, the Straits Times Index (SGX: ^STI), Singapore’s market barometer, has an average PE ratio of 16.9 for the 37 year period stretching from 1973 to 2010.

But today, Sembcorp Industries’ shares have declined by 46% in price to just S$2.94. The company’s low valuation has offered no protection at all from a big short-term price decline.

This brings me to the second point: Buying cheap stocks requires patience.

The story with Sembcorp Industries isn’t over yet – for all we know, the company’s business performance over the next five years can drive its stock higher, such that even the price of S$5.49 at the start of 2014 will look like a bargain on hindsight.

No one can tell for now with Sembcorp Industries. But in any case, there are good examples from history that lend strength to my second point. Let’s have a look at two charts.

S&P 500 annualised return (1-year period)
Source: Robert Shiller; author’s calculations

The first is a chart plotting the S&P 500’s returns for a 1-year holding period against its starting valuation. (The S&P 500 is a well-known US stock market benchmark.) It’s a messy chart. There’s no discernable pattern. Buying stocks when they’re cheap can result in a lousy return just as easily as a good return.

Now, have a look at the second chart.

S&P 500 annualised return (10-year period)
Source: Robert Shiller; author’s calculations

It is similar to the first chart, except that I’m plotting the S&P 500’s returns for a 10year holding period against its starting valuation. I trust it’s obvious to see that a clear pattern now emerges: Those who buy stocks at low valuations will likely earn a good return over 10-year periods while those who buy stocks at high valuations likely won’t.

It’s a good example of how patience is needed for successful investing even when we’re buying cheap stocks.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.