Why Buying the Cheapest Stocks in a Downturn Could Cost You Long-Term Gains

By: Rimi

Published on: Apr 16, 2025

Investors navigating today’s turbulent markets face a critical dilemma: Should they chase seemingly "cheap" stocks during a downturn, or focus on fundamentally sound companies trading at fair valuations? Recent economic shocks—from extreme U.S. tariffs to stagflation fears—have intensified this debate. While the allure of discounted stocks is strong, history shows that blindly pursuing bargains can be a costly mistake.

In this analysis, we’ll explore:

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  Why market downturns tempt investors toward low-quality stocks

  
  


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  The risks of prioritizing price over fundamentals

  
  


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  Case studies of resilient companies (like FTSE 100’s Diploma)

  
  


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  Strategies to build a portfolio that thrives in volatility and recovery

  
  

The Allure—and Danger—of "Cheap" Stocks in a Crisis

The FTSE 100’s 8% annualized returns since 1984 prove equity markets eventually recover from even the worst crises. However, not all stocks participate equally in rebounds. During the 2008 Global Financial Crisis, for example:

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  Quality survivors: Companies like Unilever (+189% from 2009–2019) thrived due to strong balance sheets and pricing power.

  
  


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  Value traps: Banks like RBS collapsed by 90% and never fully recovered.

  
  

Yet in downturns, investors often gravitate toward deeply discounted stocks, lured by:

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  Low P/E ratios

  
  


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  High dividend yields (often unsustainable)

  
  


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  Short-term momentum

  
  

This approach ignores a critical truth: Cheap stocks are often cheap for a reason. Companies with weak margins, excessive debt, or outdated business models rarely outperform during recoveries.

Why Quality Trumps Price in Volatile Markets

1. The Myth of the "Bargain" P/E Ratio

A low price-to-earnings (P/E) ratio signals affordability, but it can mask underlying risks:

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  Erosion of earnings: Cyclical firms (e.g., commodities) may see profits vanish in recessions.

  
  


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  Debt burdens: Heavily leveraged companies risk bankruptcy if interest rates rise.

  
  

By contrast, premium-priced stocks often reflect:

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  Durable competitive advantages (e.g., brands, patents)

  
  


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  Consistent earnings growth (even in downturns)

  
  


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  Strong cash flow to fund innovation and acquisitions

  
  

2. Case Study: Diploma PLC (FTSE 100)

Despite a 17% drop in two months (as of April 2025), Diploma exemplifies why quality matters:

Key Strengths:

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  Acquisition strategy: 40+ purchases in 5 years, diversifying revenue streams.

  
  


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  Balance sheet: Net gearing of 56% and interest coverage of 11x.

  
  


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  Resilient demand: Seals and gaskets are essential across industries.

  
  

Though its P/E of 27.2 seems high, Diploma’s 62% gain since October 2022 (vs. FTSE 100’s 18%) justifies the premium.

The Hidden Risks of "Bargain" Stocks

1. The Value Trap Cycle

Companies trading below book value or with single-digit P/E ratios frequently face:

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  Structural decline: E.g., traditional retail vs. e-commerce.

  
  


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  Dividend cuts: BP slashed its dividend by 50% during the 2020 oil crisis.

  
  


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  Liquidity crunches: Carillion (construction) collapsed in 2018 despite a low P/E.

  
  

2. Volatility ≠ Opportunity

The FTSE 100’s 2025 swings reflect tariff fears, but knee-jerk reactions to volatility often backfire:

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  Panic selling: Locking in losses on quality holdings.

  
  


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  Speculative buying: Gambling on penny stocks with no moat.

  
  

Building a Crisis-Resistant Portfolio

1. Screen for Fundamentals, Not Just Multiples

Prioritize companies with:

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  ROE > 15%: Indicates efficient capital use.

  
  


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  Debt/EBITDA < 2x: Room to maneuver in downturns.

  
  


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  5-year earnings growth > 10%: Consistent execution.

  
  

2. Sector Diversification

Balance cyclical and defensive exposure:

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  Defensive: Healthcare (GSK), utilities (National Grid).

  
  


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  Growth-at-a-reasonable-price: Tech (Sage Group), industrials (Ashtead).

  
  

3. Embrace Dollar-Cost Averaging

Invest fixed amounts monthly to mitigate timing risks. For example:

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  Diploma: Buying dips during tariff-related selloffs.

  
  


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  Unilever: Accumulating shares during inflation spikes.

  
  

The Long Game: Historical Precedents for Patience

Market history is littered with examples of quality prevailing:

These companies shared common traits: pricing power, low debt, and irreplaceable products.

Conclusion: Resist the Siren Song of Cheap Stocks

While downturns test investors’ resolve, the data is clear: Quality compounds over time, while cheap stocks often stay cheap. Instead of fixating on P/E ratios or short-term dips, focus on:

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  Sustainable competitive advantages

  
  


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  Balance sheet resilience

  
  


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  Proven management teams

  
  

As Questor’s Diploma case shows, paying a premium for excellence beats gambling on bargains. In the words of Warren Buffett: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Actionable Steps:

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   Audit your portfolio: Weed out companies with weak margins or excessive debt.

   
   


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   Reinvest dividends into high-conviction holdings.

   
   


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   Use volatility to incrementally build positions in quality stocks.

   
   

The FTSE 100 will inevitably rebound—but only disciplined investors will maximize the recovery.