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Weekend Wisdom

Buying stocks under $5 is like buying a lottery ticket. It's the thrill of the "what if".

Take a stock like social gaming company Zynga. It went public in December 2011, traded as high as $15.91 in early 2012 before the stock plunged due to disappointing earnings.

Recently it traded as low as $2.10.

I know what you're thinking. That stock is "cheap", right?

But just because a stock is trading under $5 doesn't mean it's cheap and should be added to your portfolio.

On the contrary.

"Cheap" stocks could be the ultimate fake out for your portfolio.


"Cheap" Doesn't Mean You Should Own It

Many investors think a stock trading under $5 is "cheap." In many investors' minds, a hot tech company that just went public only a year ago, like Zynga, can't simply "go away", despite what we've seen with companies like Webvan and Pets.com during the Dot Com Boom.

After all, you can buy A LOT of shares for $2.10.

All it needs to do is go to $4.20, and you double your money.

It's around $2. How much lower can it go? Why not take a chance?

It's easy to see how the gambling mentality takes over with low priced stocks.


Don't Be Fooled by Low Share Prices

Don't get sucked into only looking at the price of the stock to determine if it is a bargain. The stock price is, really, irrelevant. It's all about the earnings in conjunction with the share price.

For example, storage maker Western Digital appears "expensive" as the stock trades at nearly $34 a share. But analysts estimate F2013 earnings around $7.72 per share. That would give the company a forward P/E around 4.4. Now that is cheap.

Or consider IBM. Many see it as an "expensive" stock simply because it is trading around $189 a share.

But if you look beyond the share price, you can find IBM's true value.

IBM is expected to produce double digit earnings growth this year and it has $11 billion cash on hand.

It has a median forward P/E of 14 over the last 10 years, but is trading at just 12.7x right now.

Based on its fundamentals, IBM is actually quite "cheap" despite the $189 share price.

More . . .

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Volatile Markets Create "Cheap" Stocks

The stock market has been on a roller coaster in the last year with the uncertainty over the debt ceiling, the Eurozone debt crisis, the U.S. election and now the Fiscal Cliff. Several big name stocks have fallen under $5.

Just because a stock is low priced doesn't mean it's a value stock. Far from it. Buy earnings, not share price.

Look at price-to-earnings ratios and other value fundamentals first. Use the Zacks Rank to find companies with rising earnings estimates.

What will be the fate of investors who bought Zynga a few weeks ago at $2.10?

The stock bounced back briefly but is now getting hit again on news that the company's relationship with Facebook has changed, which has implications for the company going forward.

"Cheap" or low priced doesn't always equal "value". Don't be fooled. Buy value first. Your portfolio will thank you.


Where to Find Real Value

I am directing a Zacks portfolio that searches not for cheap stocks but for outstanding companies that are currently trading at least 25% to 50% below where they should be. Our mission is to signal "Buy" at just the right time - as the market begins to catch on and their stock prices begin to rise.

The Value Investor includes 23 stocks that are "on sale," and are likely to head a lot higher in months and years to come.

Even more importantly, I am getting ready to pull the trigger on new recommendations, and you will have the opportunity to get aboard at the ground floor for the full ride upward. This is a value service, so I am glad to report that you can receive a substantial discount until Tuesday, December 4.

Find out more about the Zacks Value Investor portfolio >>

Good Investing,

Tracey

Tracey Ryniec is Zacks' Value Stock Strategist and serves as Editor in Charge of the Value Investor. You can follow her on twitter at @TraceyRyniec.

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