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Wednesday, June 08, 2005 6:14:13 PM

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Cheap Stocks are Cheap for a Reason
William O'neil

New Highs: New Price Highs Mean New Opportunities

Many investors have passed up great stocks because they had reached new price highs. Yet, that's when many of the best stocks begin their major climbs, not when they've bottomed out. That's why buying bargain-priced stocks is often a frustrating experience.

Buy High, Sell Higher

How many times have you heard the phrase, "buy low, sell high"? This is the conventional wisdom in the investment world, but research shows you shouldn't be concerned with that part about buying low. Let's walk through this one step at a time. Research shows that the best-performing stocks make new highs before they make their major leaps in price. Moreover, stocks at new highs tend to continue moving higher, while stocks making new lows tend to continue to move even lower.

This is a concept many investors find difficult to accept. They assume it's too late to buy a stock that's reached an all-time high. But the great paradox of the stock market, as Investor's Business Daily Founder William O'Neil calls it, is "What seems too high and risky to most investors is likely to continue rising. And what seems low and cheap usually goes down."

Think about it. If a stock goes from $15 to $50 it has to reach new highs at $16, $17, $18 and so on. Stocks making new lows, on the other hand, manifest inherent weaknesses.

Just by applying the laws of supply and demand you can see why new highs are important. When stocks advance, they're demonstrating growing demand as investors raise their expectations about the company. On the other hand, stocks making new lows are usually afflicted by just the opposite: sagging expectations. Yes, there's plenty of stocks in the bargain basement, but they're there because the merchandise, so to speak, isn't hot.

Some stocks may have very strong fundamentals or great stories, yet they don't go up because there's little investor interest. So while you wait for a stock to be discovered -- if it ever does -- other stocks are moving into the spotlight. The spotlight, in a way, is the new-highs list, such as the one that appears daily in IBD and is explained later.

Stocks reaching new highs tell you professional investors are moving in and pushing prices higher.

Often, The Best Is Yet To Come

Would you shy away from stocks that more than doubled in the past year or less? Consider what happened with these stocks:

From the start of 1999 to August 1999, Qualcomm surged more than 500%, to $39. But the stock didn't let up, finishing the year at $176 -- a gain of 351% since August.

Jabil Circuit had grown from $11 to $27 in about nine months ending in May 1997, when it surged another 189% over the next five months.

In a good market, opportunities such as these, which start with new price highs, will surface every two or three weeks. In fact, if you ignore this simple rule, you would miss out on just about every major winning stock.

However, there can be such a thing as an "overextended" stock: one that truly has gone up too much, too fast and is likely headed down. As a rule, don't buy any stock that has risen more than 5% past its buy point. In a nutshell, the buy point is the price after a stock clears the highest point in its basing formation. Basing formations are periods of price consolidation when a stock moves more or less sideways for a number of weeks after earlier advances. The buy point and basing formations are explained in the stock charts lesson.

Avoid Cheap Stocks

Perhaps you're one of those investors who think they'll hit the jackpot buying a low-priced stock that goes on to make huge gains. Some investors equate cheap stocks with better value or low risk. If a stock costs just $5 a share, then you can't lose a whole lot, right? Wrong. The truth is that trying to consistently make money with cheap stocks is difficult, at best. Think of a stock's price as a measure of its quality and, consequently, its potential. Stocks selling at $10 or less have a much smaller chance of making major advances, because they're usually companies lacking good performance records. Also, professional investors shun low-priced stocks because they tend to be lightly traded, making it harder to move in and out of such stocks.

A study of the best stocks of 1996-97 found that, on average, they made their big jumps when trading at about $25 a share. Only three of the 120 top stocks were trading at less than $10 a share in that period.

So, you can see what research bears out: it's best to look for new highs in quality stocks. It's especially good when the stock is coming out of a base. But don't wait too long: As soon as you spot a buy point -- and if all other factors are in place, such as good earnings growth -- it's time to have confidence and conviction and make your move. Otherwise, you may miss your opportunity.

The first chart shown above shows Dollar General's stock coming out of a so-called flat base (A chart pattern in which the stock price moves basically sideways for at least five weeks or more. It often precedes a further price advance. This and other chart patterns are explained in the Stock Charts lesson.) on a surge in trading volume. After this point, in July 1982, Dollar General's stock surged about 340% over the next 14 months, which is shown in the second chart, which has been adjusted for a stock split.

Avoiding Pitfalls

Like you've seen in earlier chapters, you don't want to buy a stock on any single factor. Where a stock is in relation to its 52-week high and low price is just one part of your stock-selection checklist. Other important ingredients are the Earnings Per Share (EPS) Rating, the Relative Price Strength (RS) Rating, the Industry Group Relative Strength (Group RS), and so on. These concepts are explained in the lessons on earnings, leaders and industry groups.

Also, be careful with stocks that make new highs on less and less trading volume. This could be a sign of a stock topping (reaching its peak), especially in cases when a stock has gone up at least 50% in a few weeks after an extended advance. When a stock goes up on low volume, it's a gain produced by relatively small purchases. It's much safer to go with a stock that makes a new price high on higher volume, which indicates broader support for the stock.

Key Points To Remember

Quality stocks making new price highs just as they emerge from sound bases on higher volume are often likely to continue climbing, while stocks making new lows are probably headed even lower. Therefore, focus on the new price highs list for the best potential opportunities.

The great paradox of the stock market is that what seems too high and risky to most investors is likely to continue rising. And what seems low and cheap usually goes down.

You can think of a stock's price as a measure of its quality and, consequently, its potential. Typically, stocks higher in price reflect higher quality.

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