How Can I Identify Undervalued Stocks?

Takeaways

• What is an undervalued stock

• Know what to look for

• Why fundamentals are important

What are undervalued stocks?

They are stocks whose intrinsic value is higher than their valuation. In other words, they are unloved stocks. This can be for a variety of reasons, company specific problems, creative accounting, geopolitical risk, sector risk or that the market has misunderstood the investment case and therefore the opportunity.

Small is better…

As an individual investor you have the freedom to invest your stock portfolio as you please, and are not bound by internal firm conflicts which invariably damage the investment process. This means price discovery is possible for you.

This freedom allows you to invest in companies that may be unpopular, (Tobaccos and arms) or out of fashion (Oil companies). Although not expressly a rule, investing where others shun their noses is often the most rewarding. This is a well trodden path for a contrarian investor.

It pays to be a contrarian.

What is the point in paying for overvalued stocks which have already fulfilled their (upward) potential and will likely be punished (sell off) severely if they fail to meet their financial projections?

Be a tortoise and not a hare

There are many individual investors who buy and sell stocks based on tips and emotions. This hare like approach rarely leads to long-term success. Buy and hold investors often outperform day traders.

Tortoise like operators who perform fundamental analysis on different companies, and start to build up a knowledge of a company, such as its strengths and weaknesses are the ones who will prevail.

As the aforementioned disciple of Benjamin Graham, Warren Buffet famously bought into American Express which had just suffered a grievous blow.

It has been victim of a fraud (a major weakness) but had a stellar brand (a huge strength) to leverage if it took the right long-term action. This meant reimbursing victims of the fraud. This painful but long-term thinking ensured it kept its stellar brand and Warren Buffet was able to profit handsomely.

Critically he fought to stop those trying to make a quick buck whose choice of action was short-termism (by refusing to reimburse victims) and would have destroyed the brand. Sometimes a profit warning can be a positive!

Look under the bonnet

Another famous and dominant US brand is Mcdonald's, the eponymous fast food chain. In the film The Founder, which is a documentary film on the birth of Mcdonald's, the lead character sees one opportunity, without realising the bigger, more rewarding opportunity.

This is where the tortoise like hard work comes in.

The more you understand about business, the more you understand the upside risk in front of you. Having been initially attracted by the fast food nature of Mcdonald's service, 'the founder' realises that there is more money to be made by being a real estate magnet.

Love thy math teacher!

Of course, investing means a lot of 'noise'. This is where different commentators, hedge fund managers and investment banks will give you their opinion on a stock. At the heart of it though is mathematics. How much profit does the company behind the stock make? In particular how much cash? Always treat an income statement with a heavy dose of cynicism but learn to love the cashflow statement. If the company is generating free cash flow of £200m but has current liabilities of £400m, is this company in such a good financial position? Indeed what is the margin of this company's key product?

If the margin is in double digit % then it can withstand some competition by lowering price (if it chooses to compete on price). If its margin is 2 or 3% and its costs increase, will there be any (profitable) margin left?

Giving yourself a margin of safety is also sensible. As a (simplified) rule, a company with no debts, strong cashflow and good margin is always worth a look. On the downside, it may well be expensively priced! You will only know by looking at the financials and then looking at the share price and its P/E ratio to see if it is undervalued.

Conclusion

Different people will have different views as to what undervalued stocks look like. Some undervalued stocks are nothing more than value traps. They are cheap, undervalued and will never get any better… i.e. traps! Do not waste your money or time on them.

At the core of identifying undervalued stocks is a great deal of work researching every part of the company. Once you feel you can predict (to some extent) how a company reacts or handles particular issues, then you have gained a good knowledge. This will come in handy when that stocks sells off and allow you to identify with confidence any undervalued stocks!