Choosing undervalued investments that the market has ignored or misunderstood can be very profitable. But, the key to this manner of investing in stocks is to find investments with hidden value and not just use a stock screener to find cheap investments. There are always reasons why the market prices a given stock as it does. Investments that are really undervalued are being ignored by the market because they are small stocks, stocks that no analysts are following, or stocks that the market in general does not understand and therefore gives them a too-low stock valuation.
Because the stock is being ignored, the company could be making significant changes that will result in long term profits and no one would know. The key to choosing undervalued investment is to recognize and exploit such situations. And, the funny thing is, many such investment opportunities are hiding in plain sight and not just in small cap or mid cap stocks. Choosing undervalued investments in large cap stocks is possible as well. In those cases the issue is one of the market not understanding a stock’s long term growth potential.
Image: US News and World Report
How to Go about Choosing Undervalued Investments
When looking for undervalued investments do not assume that you need to look for penny stocks under $1 or stocks that nobody has ever heard of. Although screening for cheap stocks is not a good way for choosing undervalued investments, there are sources of information you can tap. You can subscribe to an investment advisory service such as Morningstar Stock Investor, Kiplinger’s, or simply read the Motley Fool’s advice. The point is that you can get good ideas from these folks without a lot of effort. But, then you need to do your own homework.
Situations That Result in Undervalued Investment Opportunities
The Motley Fool has some good advice about finding an undervalued stock. The first step is to understand just why the stock is undervalued, as opposed to correctly valued and cheap.
One of the central ideas of value investing is that the market misprices stocks from time to time. There are many potential reasons why a stock can become undervalued, but these are a few of the more common ones:
- Missed expectations: If a stock reports quarterly results that fall short of expectations, shares can drop more than the situation calls for.
- Market crashes and corrections: If the entire market drops, it’s a great time to look for undervalued stocks.
- Bad news: Just like when a stock misses analysts’ expectations, a bad news item can cause a knee-jerk reaction, sending shares plunging more than they should.
- Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Sectors that are out of favor are good places to look for bargains.
In each of these cases, the market drives a stock price down below what it is worth over the long term. This can be simply a panic response to a falling market or in can be an over-leveraged investment group that is forced to sell at a discount in order to cover margin calls on options trades that went badly. In either case, these are classic situations in which choosing undervalued investments can work out well.
Image: Market Watch
Choosing Undervalued Investments in Your Areas of Expertise
The most important part of making money by choosing undervalued investments is to always work within your area of expertise. This can be you profession. A computer scientists will have more insight in this area than someone else. Or a medical doctor ought to have more insight into the pharmaceutical industry or medical products companies. But, your area of expertise can be one in which you have studied the investment opportunities, have invested for years, and in which you have experience with rising and falling markets. The point is that when you are investing on your “home turf” you will have a much better sense of when an investment is undervalued.
Specific Guidelines for Choosing Undervalued Investments
There are a whole set of “metrics” that you can apply to come one investment to another or than investment to its market sector as a whole. Using these is not the whole story but a good place to start.
This is the share price of the stock divided by annual earnings (price to earnings ratio). A really high P/E ratio usually indicates and overpriced stock and a really low P/E ratio typically goes with an undervalued investment.
The price to book ratio is the share price divided by the company’s equity per share. This metric has to do with the margin of safety of a stock. Companies with lots of cash on hand and very low debt have low P/B ratios can be good undervalued investments to consider.
Price to earnings growth is based on its P/E ratio which you can calculate and its earnings growth projection is an estimate which you need to work out or trust someone else to provide for you. The argument for using this indicator is that there are stocks that are growing rapidly and therefore attracting lots of investors at higher share prices. The argument is that you are paying a lot for this stock today but its growth will still make you rich. Choosing undervalued investments using this metric takes a lot of faith and, some would say, gullibility.
Return on equity is the company’s net income for the year presented as a percentage of total shareholder equity. This is a useful metric as it gives you an idea of how well the company generates revenue in light of the total money invested in its stock by investors. This metric can be used to compare companies within a sector, but beware of using it across the board because different kinds of businesses typically have different returns on equity.
Debt to Equity Ratio
This is another margin of safety metric. It is the total company debt divided by total shareholder equity.
This one has to do with short term cash flow and the ability of a company to pay its immediate debts. It is current company assets divided by current liabilities. When choosing investments that are undervalued and otherwise seem like good prospects, beware of this one because it could predict that the company will run out of money and credit before accomplishing the changes needed to grow profitably.
(The Motley Fool)
Non-metric Indicators and Predictors of Stock Value
Established companies may or may not have an advantage over upstarts in an industry. But, many areas of high tech are “high cost of entry” businesses. When a company has money in the bank, low debt, a strong brand name, and the ability to reduce prices to freeze out competition, they have a huge margin of safety. Over the long term this argument can apply to a variety of businesses but is one of the reasons why successful long term investors step in and buy more shares of companies like Microsoft or Walmart when their prices go down.
Another indicator to follow is when company executives buy or sell stock in the company. It is reassuring to see the folks in charge buying more stock during a market downturn instead of selling out and heading for the door. Keep track of this when choosing undervalued investments.
The Virtue of Patience in Choosing Undervalued Investments
We often mention Warren Buffett in our articles. He is one of the richest people in the world and unlike the others in the top echelon like Bill Gates, the Walton family, and Jeff Bezos, Buffett’s wealth does not come from a single company in a single market niche. His wealth comes from investing and his holding company, Berkshire Hathaway. Buffett has become incredibly rich over the years by successfully choosing undervalued investments which he commonly goes on to hold forever.
The point of mentioning Buffett has to do with the general approach to choosing undervalued stocks. Buffett only invests in a company when he has a clear idea of what they do, now they make money, and how they will continue to do for a long, long time. When he and his staff look for new investment opportunities, they look for intrinsic stock value which is determining a stock value based on the assessment of forward looking earnings and then comparing that value to the current stock price.
He has been quoted as saying that he throws out 95% of all investment prospects as “too difficult to call.” This is a good example for the normal investor to follow. Be patient and find stocks with good intrinsic value that have been beaten up or forgotten by the market. Luckily for investors who are mere mortals and not Warren Buffett, we only need to find a handful of stocks to invest in and not a hundred in order to reinvest billions in profits every month!