The phrase 'cheap ASX shares' will probably have a similar reaction among the ASX investor community as Pavlov ringing the dinner bell. But if I instead said 'beaten down ASX shares', I'm sure the reaction wouldn't be as enthusiastic. Yet they are 2 sides of the same coin. It's a dilemma well worth exploring today: how to tell if an ASX share is cheap, or worthless.
Since the dramatic share market crash we saw back in March, much has been made of the recovery trajectories of a number of ASX shares. Take Afterpay Ltd (ASX: APT) for example. Its share price touched $8.01 on 23 March. And yet today, Afterpay has stormed past the $100 a share mark, trading 4.95% up at $102.37 at the time of writing. Investors who bit the bullet and 'bet big' on Afterpay on 23 March would be enjoying gains of close to 1,000% right now.
And yet, other 'cheap' shares on 23 March haven't done so well. Take Virgin Australia Holdings. I'm sure there were a few ASX investors who thought they could snare a bargain with Virgin shares back in March. But that was before Virgin went bankrupt and took its shareholders with it down the rabbit hole. Virgin is still around, but not on the ASX anymore. Not such a bargain in hindsight!
Cheap and/or cheerful
Share market crashes are scary events, but the one redeeming thing about them is that all ASX shares (regardless of quality) are usually sold off, not just the ones in real trouble. That's why we saw companies like Newcrest Mining Limited (ASX: NCM), and Telstra Corporation Ltd (ASX: TLS) sold-off in March, despite the pandemic posing very little threat to a gold miner or a telco. Long story short: the baby gets thrown out with the bathwater in a crash.
This is the thing we investors can use to our advantage.
So ask yourself these 3 questions next time you find yourself a cheap ASX share
- Is this company cheap for a good reason, or is it cheap because of a temporary problem? — Many investors (especially those in the funds management business) will sell a share if they think it has a nasty few months ahead of it, even if the business is fundamentally sound. Thus, those investors with a longer time horizon can take advantage of these dips.
- Does the company have something special that protects it? — A strong brand or a 'needs-based' product can go a long way. Just look at how the Apple Inc (NASDAQ: AAPL) share price has performed in 2020. Many investors (myself included) assumed that Apple would have a tough year due to the pandemic-induced global recession. But Apple's brand is so powerful that it protected the company (and even allowed it to grow) in what has been an exceptionally tough year.
- How much debt does the company have? — The thing that usually causes a company to go bankrupt is too much debt (Virgin is a great example). Put simply, if a company has a large debtload, it is far more at risk from going under during tough times. Airlines by their nature are high-debt businesses, whereas software companies don't need it to the same extent.
Foolish takeaway
Most ASX shares that are cheap are so for a reason. But if you can find a cheap ASX share that is cheap for a flimsy reason, you might find yourself a bargain instead of a dog. It's a fine line, but if you can master it, it's a very lucrative pathway to follow.
