Stocks

The One Critical Lesson Most Income Investors Ignore

When it comes to buying stocks, nearly everyone is looking for some kind of "deal."

Think about it this way. If you saw a book selling for $5 at a store, with a $10 bill sticking out of its pages, you'd be crazy not to buy it. You probably wouldn't even check to see what the book title was.

That's an instant 100% return on your purchase because the book held more value than what its sticker price said.

Years ago, before I took charge of my premium newsletter advisory, High-Yield Investing, I hunted for stocks in a similar way. Finding high-value companies with low share prices often led to triple-digit returns.

Craft Brew Alliance (Nasdaq: BREW), for example, went on to produce a stellar gain of 153.4% in the year after I recommended it. Exchange-traded fund issuer Wisdom Tree (Nasdaq: WETF) surged 189.4%. Of course, the first reason I bought these two stocks in the first place was because both stocks were undervalued.

But here's the part that most investors all too often ignore when they buy undervalued stocks... Cheap stocks can sometimes drift aimlessly and stay cheap. Or worse, they could be "falling knives" with share prices that plummet way below what you thought was "a good deal."

To prevent those situations from happening, I use another key element in my investing approach. It's one that applies to any stock -- growth or dividend stock -- and it helps ensure that I get high returns in a reasonable amount of time.

You see, finding a "value" stock whose price is a great distance away from what it's truly worth is only half the battle. You also have to consider how long it will take to make the journey.

Imagine two stocks trading at $30 that are arguably worth $40. Both would seem to offer the same upside potential. But the first might sprint and make the trip in just one year, giving investors a 33.3% return, while the second trudges slowly and takes three years, for an annualized return of just 10.0%.

Everyone would prefer the first stock -- which is why I preached to my subscribers the importance of identifying specific agents of change that can propel an investment rapidly upward.

Introducing: Catalysts

Of course, I'm not searching for aggressive growth stocks in my High-Yield Investing advisory. But if some of our holdings happen to shoot higher, I certainly won't complain, particularly when their dividends are also marching higher.

And that's what catalysts are all about. Catalysts are key to ensuring that stocks you buy at a discount will actually lead to a fast turnaround in gains.

Simply put, a catalyst is any event, development or trend that makes investors want to jump on a stock or industry group.

It could be the launch of a hot new product or penetration into a foreign market. Or it could come from belt-tightening, if, for example, a retailer exits an unprofitable business line or a real estate investment trust sells a weak property.

Some catalysts come from big strategic shifts -- acquisitions, spin-offs or other major business restructuring. Others could be external, like the missteps of a key competitor. Even the weather can be a strong catalyst.

Catalysts can come from almost anywhere... rising crop prices, falling interest rates, patent infringement lawsuits, outspoken shareholder activists. They can all elicit a sharp increase in stock price.

Here are more typical examples:

-- Pharmaceutical company: long-awaited FDA approval of a potential blockbuster drug that could bring in millions in new sales.

-- Energy Producer: the discovery of a massive offshore oil field that promises a big increase in production and reserves.

-- Lumber mill: a sharp rebound in housing construction that leads to new orders for 2X4s and plywood.

-- Defense contractor: landing a plum multi-billion dollar weapons procurement deal.

How You Can Profit From Catalysts

Some of the most powerful catalysts come from legislative changes, regulatory overhauls, and anything else originating from the Federal government. Whether it's a narrow protective trade tariff or green energy subsidy that impacts one niche or a broad stroke like monetary policy that paints everything, the decisions handed down in Washington always work for some stocks and against others.

And unlike the fleeting 2% bounce you might see from an analyst upgrade, these catalysts typically have a lasting impact. That's what I'm looking for: gusty tailwinds that can last for months or even years to come, particularly when there are billions riding on the line.

Simply put, finding under priced stocks may net you a return on investment over time. But it's the catalysts that make bargain investments turn into large returns quickly rather than drag out over years.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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