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3 Keys to Cheap Stocks with Big Upside Potential

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Low-priced stocks are the things that investment dreams are made of. We have all fantasized about buying a stock in the single digits and watching it soar higher.

Too often, however, investors never realize that dream.

For any number of reasons, investors often buy a low-priced stock only to sell it at an even lower price. This common practice is really quite curable.

The mistakes investors make when dealing with low-priced stocks have simple answers. Most of the time you already know what the answers are; it is the execution that is hard. I want to share some of these common problems and give you the solutions so that you can become a better investor.

Beware Buying the Bottom

Everyone wants to get something for nothing, and if you can't do that then paying as little as possible is the next best alternative. I mean let's face it, who wouldn't want to buy at the 52-week low and then sell at the 52-week high?

The problem is that sometimes the bottom you see is not at all the bottom. Usually, stocks making new 52-week lows are not the stocks you should be buying. The market is telling you that this stock is consistently worth less and less when it appears on the list of the 52-week lows.

Bottom feeding is fine for some species, but investors that want to see good returns in a reasonable amount of time should avoid stocks at their "perceived" bottom. Always look for confirmation that the bottom is in and the stock is recovering. 

Adjust Your Risk Profile  

Buying a low-priced stock sometimes seems like a riskless or a very limited-risk venture. The stock is in the single digits and how much more can it go down? The answer to this one is always the same thing.

Any and every stock can go down 100% from where it closed the day before. Rarely does this happen, but the point is you have to think about returns more in percentages than stock prices. A $7 stock going to $3.50 is a loss of 50% and that is a hard-to-swallow number.

The solution to this problem is position sizing. You must know how much of your portfolio should be dedicated to low-price stocks and not put all your eggs in one basket. This is an issue that is unique to every investor, as everyone has a different amount of investable dollars, and most have a different time horizon as well. Proper position sizing will allow you to withstand short-term loss and also encourage long-term success.

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Don't Double Down

Many investors believe that the stock they pick is destined to succeed. I mean, they did their research (sparse as it may or may not be) and came up with the idea so it probably has some merit, right?

This sort of confirmation bias leads many investors to double down on a bad idea. When an investor buys a stock at $8 and then doubles down at $6, the problem only becomes a bigger one when the stock slips to $5. Now you have twice as many shares losing more money with every tick!

The discipline to cut losers and let winners run is something that even the most seasoned professional has trouble with. Assess the amount that you are able to withstand in a pullback and stick to those limits. Oftentimes, small-priced stocks have a way of really falling out of bed when there is trouble...and no one wants that.

My Best Advice for Making Big Profits with Low-Priced Stocks

Be patient with your investments. Low-priced stocks generally need more time than their bigger brethren. A healthy dose of patience will go a long way for a low-price stock portfolio.

Leverage the Zacks Rank to help find stocks that analysts see earning more money. The Zacks Rank looks at earnings estimate revisions of the models from all the covering analysts and compares it to all stocks in the Zacks universe of coverage. When an analyst at Needham or William Blair moves numbers higher, the Zacks Rank helps you know when estimate increases are the most meaningful.

Assessing risk is a difficult task and something only you can do. One way to limit risk is to spread the exposure to several low-priced stocks. Instead of going "all in" and buying 10,000 shares of a single-digit stock, spread that out among several names. A larger portfolio will spread the risk out across several names, giving you a better chance to succeed. 

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Best,

Brian

Brian Bolan is our aggressive growth expert and the editor of Zacks Stocks Under $10 portfolio.

¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research’s newsletter editors and may represent the partial close of a position.