Think about it: Most of the time, you're better off buying the cheapest house in the priciest neighborhood and waiting until the end of the season before you buy designer shoes or dresses. And who hasn't heard a story about some savvy art collector who picked up an Old Master for $10 at a yard sale only to have it appraised for much, much more?
If only the stock market worked that way. The truth is that, when a high-flying stock comes crashing back to Earth, there's usually a reason why--slumping sales, management turmoil or a negative earnings report, to name just a few.
That's why scraping the bottom of the barrel for stock market bargains rarely makes good investment sense. Shortly after the dotcom bubble burst 10 years ago, a friend of mine told me that he was interviewing at an internet company that had offered him options at $4 a share. Just a year before, the company's stock had been trading at over $100. Against my advice, my friend took the job, figuring that the stock had nowhere to go but up. Six months later, the company laid him off, and his options expired worthless.
That's why it's important to look beyond price when deciding which stock to pick. While a stock may be temporarily undervalued due to market conditions, a stock that's a dog usually comes with fleas.
Let's say you're considering two stocks, both of them trading at around $15 a share. The first stock, ABC Corp., hit a 52-week high of $50 last year but lately has been trading in the $10 to $15 range. The second stock, XYZ Inc., went public at $10 a share six months ago and has since moved up to $15.
Which stock should you buy? I don't know about you, but I'd rather put my money on XYZ Inc., the little company that could, than on ABC Corp., an old war horse that must have disappointed investors in a big way in order for its stock to have taken such a beating. To me, a young company with a bright future is a better bet than a mature company struggling to recapture its former glory.
Here's something else to consider: Just because a stock has had a big run-up doesn't necessarily mean it's headed for a fall. Anybody who bought Google for $85 at the IPO would still be sitting pretty today. But does this mean that Google is still a buy at yesterday's closing price of $542.80? That's a tougher call.
