You don’t have to be Warren Buffett to know how to find undervalued stocks. In fact, there are several types of undervalued stocks and many ways to find them.
Traditional value investors tend to put too much emphasis on low price-to-book and low price-to-earnings. You can still find undervalued and interesting stocks by screening based on those metrics, but just remember that every analyst on Wall Street and retail investor already knows how to do the same.
So if you do not do your due diligence, you will end up with value traps all over your portfolio.
Thus, you need to find new ways of looking for stocks that are undervalued and that can be great investments.
How do you find undervalued stocks?
Here are 8 ways of finding undervalued stocks that can boost your returns:
Trading under book value
Low book value per share and low price-to-earnings can be deceiving, and you need to dig deeper in order to understand the undervaluation. When the market attributes a low price-to-book it means that the company’s outlook is not very positive.
This does not mean that the stock should be ignored. However, what you need to understand is why the market is pricing that stock under book value. By understanding the reasons behind the undervaluation, you can then project how the market could value the stock higher.
What to avoid:
Try to avoid situations where the book value has been decreasing over the past few years. This is a sign that either the company’s assets are declining in value, or it is accumulating liabilities.
You will also find companies in beaten-down sectors that you should avoid. This is because the market consensus on that sector is negative, and it won’t change overnight.
Trading under cash
Not as often as stocks trading under book value, but sporadically there are stocks trading lower than the cash they hold. This means that the company has more cash on its balance sheet than the total market value.
This is a rare occurrence that was more common back in Graham, and Buffett’s days. They would pick up these deep value stocks.
Today there are still stocks like this to be found. However, they are not as common, and usually, there are several risks with them. This is one of the reasons the market is valuing them so low.
You can easily find some value stocks that have 50% or even more in cash. Sometimes even a company with 10% or 20% of its market capitalization in cash can be a real bargain if you pick the right companies.
Often you will find that the market overreacts to negative news. Exploit situations, where the stocks are overly shorted and oversold.
What to avoid:
Avoid buying this type of undervalued stock without understanding the narrative behind the valuation. If you are able to understand why the stock is trading at such a low valuation, and if there is a catalyst that could move its price, then you should consider researching more.
Another important aspect to mention is that a company that has more cash than its market cap can often be a sign of management not deploying capital efficiently. This is something to be aware of, especially if you are planning to hold the stock for the long term.
Be careful with some sectors that due to their specific operations require that companies hold a lot of cash like the banking and insurance sectors.
Asset plays
Sometimes companies hold multiple investments in other companies that are not completely priced into the stock. This is what is commonly referred to as an asset play, and it is a great way to identify undervalued stocks.
In some situations, the whole market capitalization of the stock might be lower than the company's total investment portfolio. These are some of the best value situations you can find.
You basically buy their investment portfolio at a discount, while getting the company itself for free. Make sure you research their investment portfolio thoroughly to understand what the possible risks are.
What to avoid:
It is important to determine whether the valuations of the companies in the investment portfolio are actually fair. It would be wise to avoid companies that have significant stakes in overvalued companies.
As it may reflect that the investment portfolio of this company is actually inflated. You should also be on the lookout for companies with shrinking revenues and profits. The apparent cheap price might signal negative future prospects for the business.
Growth stocks
You can find undervalued companies even among growth stocks. Growth stocks often have a higher price-to-earnings, reflecting the higher expectations. Even considering the higher price tag, all you have to do is to find a stock that beats even the most positive estimates.
There are also growth stocks with an attractive valuation that does not fully reflect their growth. Although markets tend to be efficient there are stocks where the growth is not entirely priced in.
You should look for companies that are growing but have a lower price-to-earnings ratio than their peers. Always ask yourself why this stock has a lower valuation than its competitors.
There are also companies that are unprofitable and are about to become profitable. Usually, when that happens the stock tends to jump higher as analysts adjust their estimates. This is a great way to ensure you book a great return, mainly because when a company becomes profitable the general market usually attributes a higher price, essentially rerating the stock.
Look at sectors that are trending. Ask yourself what companies are operating in the space that might have a competitive advantage and might grow faster than the estimates. Look for companies where management is top-notch and has been delivering results according to estimates or above.
Special situations
Overleveraged
Special situations are far more common than some of the examples above. There are many stocks that can be profitable situations but present a higher degree of risk.
Overleverage can happen for many different reasons. Although it is advisable to look elsewhere for value, there are some great opportunities among overleveraged companies.
Try to understand exactly why the company has accumulated so much debt and what did management do with the capital. You should also pay attention to interest expense, and how this amount compares with the cash flows generated.
You should also consider what the company is doing to tackle the debt. Is it paying it off, or refinancing at attractive terms? You should also research the type of debt the company has, and how it can affect the business.
Look for companies in which there is a positive change happening, like paying down debt faster than expected, or a great operational improvement that can lead to reduced debt levels.
Source: Insperity
M&A
Mergers and Acquisitions don't always go as planned, and this can provide investors with great returns. A company might pay a much higher price than the value of the acquisition.
It could also find some challenges integrating the acquired business. When situations like this happen you will see the stock price usually decline.
Similar to the overleveraged stocks you should look for a positive change happening. Understanding why the Merger or Acquisition didn't go as planned is another important step. Consider what is the company doing to improve the situation and if there is any catalyst for the stock price that might not be priced in by the market.
You should also consider the debt levels. Usually, M&A might be done with borrowed money and it's important to put that into perspective when considering this type of value stock.
Commodity stocks
Another interesting situation investors should consider is stocks driven by commodity prices. For example, mining stocks usually move in tandem with the price of the underlying commodity they are mining.
Investing in commodities, and understanding their price movements is far easier if you compare them to stock analysis. Because they are mostly driven by supply and demand. Understanding how the supply and demand work, and how it is traded globally are the two main goals here.
You can find commodities that due to fluctuations in supply and demand will either rise or fall. By doing so, you may find stocks whose price is driven by these commodity prices, and find underpriced stocks.
Source: Kiplinger
Contrarian
Although the market is efficient to some degree, there are still plenty of opportunities for contrarian and deep value investors. There are always undervalued stocks in bull and bear markets.
A stock price is essentially the market consensus on the value of a certain business. This is the main reason why investing is so complicated and time-consuming. When you place a trade you are going against the general consensus. Either thinking something is worth more or less.
To be successful you need to accurately find mispriced stocks. While at the same time, determine that the general consensus is attributing a price that is incorrect.
Conclusion
Finding undervalued stocks in all sorts of markets is possible. Whether you are in an incredible bull run, a bear market, or even a sideways market. The key is to look where others are not looking and try to take advantage of that.
Some of the best opportunities to find the most undervalued stocks are in emerging and foreign markets, especially if you look at small caps. You find plenty of undervalued stocks following the steps we mentioned.
Featured image source: Catana Capital