Five Tips for Buying Cheap Stocks

Not All Cheap Stocks
Are Created Equal

Cheap stocks — undervalued bargain stocks trading at big discounts, generally priced at less than $10 per share — are the way to build
your wealth. It’s just a lot easier to double your money on a $3 stock than it is when you buy one that’s trading at $50.

But for investors who either don’t know better or aren’t careful, buying cheap stocks can be much riskier than purchasing higher-priced stocks for
one very important reason: Most cheap stocks are junk and doomed to fail.

Protect your portfolio by learning how to separate the cheap stock bargains from the busts. Here are five red flags to look out for when buying
cheap stocks. In my experience, these warning signs are usually a strong signal to stay away.

NEXT – Tip #1

Tip #1 – Run away from companies with too much debt.

A thorough review of company debt is one of the simplest ways to judge if a cheap stock is worth your hard-earned money. The analysis is very simple
and doesn’t require any special investment knowledge. In fact, you can find out if a company is utilizing its debt properly with just a few basic
questions:

• How much debt does the company have?
• Is the company’s debt growing?
• Are they increasing their earnings by utilizing the debt, or has their expanded debt decreased their income?

Keep in mind that not all debt is bad — without debt, many great businesses would never have gotten off the ground floor. Debt allows a company
to grab opportunities to make extra money, including expanding their product lines, purchasing other businesses or making investments to update their
fixed equipment.

But sometimes, companies — just like individuals — overdo the debt. Their plans are too rosy, and the debt they take on not only does
not add to their income, but becomes a noose around their neck, often creating a deepening hole of borrowing money to repay borrowed money. Before
you know it, they are in big trouble, especially in a weak economy when easy credit disappears.

NEXT – Tip #2

Tip #2 – Avoid companies with a history of missed earnings.

Earnings are one of the most important “tells” when analyzing a company’s future prospects. Earnings are the pre-eminent indicator of how well the
company is progressing toward its goals, and also how well it is managing its bottom line along the way.

Since I tend to take a long-term view of the market, I don’t sweat one missed estimate — as long as I can determine that the company is on
the mend and no serious fundamental concerns have come to light.

However, if a company keeps missing estimates, that’s a different story. When that happens, it tells me that the business has some underlying problems.
Maybe it’s in an incredibly volatile industry, one in which its customers’ orders fluctuate wildly. Perhaps it’s in the process of restructuring and
can’t precisely estimate its cost savings. Or maybe they just can’t do simple math. Whatever the case, a history of missed expectations is a huge red flag to me.

NEXT – Tip #3

Tip #3 – If you see too many quarters in the red, do not invest.

If a company consistently generates cash, that puts them in an enviable position. When times get tough (like the last couple of years), they have
a cushion to get them through the worst spots. They can make their principal and interest payments, and if they pay dividends, they can continue to
do so.

The best measure of whether a stock is a good cash generator is Operating Cash Flow, or OCF. OCF is simply a tally of the amount of cash a company
generates from its primary business. Unlike overall earnings, it is not money that comes from investments, buying real estate or borrowing.

What really concerns me is: 1) when a company does not have a reasonable amount of cash on hand, but even more importantly, 2) when the operating
cash flow account (you can find it on a company’s Statement of Cash Flows) is negative and trending downward.

You do have to be careful with seasonal or cyclical businesses. For instance, an amusement park operator in Ohio probably won’t have positive cash
flow during the first quarter of the year, as it’s a little too cold to ride roller coasters in January. So, it’s smarter to look at operating cash
flow over time — not just one quarter.

NEXT – Tip #4

Tip #4 – Don’t waste your time with dividend-cutters.

The primary reason a company slashes its dividends is that it needs money, and badly. Generally, the business is in the throes of unexpected financial
events that will severely affect its earnings — current or future.

Granted, the current economy and the resulting financial pressure on companies has been unusual, so it’s a little more difficult to separate the
dividend-cutters who were merely trying to nip short-term problems in the bud from those in which the dividend cut is but the first warning of what’s
to come.

Consequently, it’s up to investors to figure out why the cut was made and whether it signifies just temporary or long-term challenges for the company.

To do that, first think about the explanation that management gave for the cut — does it make sense? Next, look at the company’s cash position.
Does it typically run pretty lean? Has it been decreasing over time to an untenable level? And finally, review the earnings trend, again, over a period
of a few years. Are they trending down, or not growing as much as their industry warrants?

In general, a cut in dividends is not a lightning bolt from the sky. Instead, it’s a continuation of bad news that will first show up in cash and
earnings.

NEXT – Tip #5

Tip #5 – Access the company’s survival potential.

Unfortunately, there is no magic formula to determine
which incubator businesses will succeed and which will fail. However, there are certain warning signs that will give you a good indication of a company’s
challenges, as well as its survival potential.

#1 – Betting it all on one product. The majority of companies — at inception — do have just one product or service. But, over
time, most will expand their offerings, either by design or by accident. That not only brings additional revenue sources into their coffers but helps
to diversify their business should one or more product lines experience a setback.

#2 – Companies dependent on outside funding. While most biotechs and pharma companies go into the business hoping to create the next blockbuster
drug, very few actually succeed, especially in an uncertain economy. Their R&D efforts require tremendous cash, and during tough economic times,
the deep pockets of venture capital funding dry up. Don’t get me wrong, we absolutely need biotech companies. But if you just have to have biotech in your holdings, make sure it is a very small portion of your
portfolio

#3 – Companies that require continued capital investment. Over the long term, shareholders make spectacular returns by buying businesses
that are able to achieve extraordinary returns on capital. This leads to excess capital that the company can use to repurchase shares, pay a dividend
to shareholders or reinvest in further growth. Companies that constantly need to make additional capital investment to keep the business going are
the antithesis of this ideal — the main beneficiaries will be employees, management, suppliers and government— not shareholders.

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