Finding undervalued stocks is not an easy task! There are many factors you have to consider and you will be presented with different situations to choose from. By following this guide and focusing on this kind of stocks you can easily identify the type of profitable situations you should be interested in.
Trading under book value
Book value can be deceiving! It requires investors to do some due diligence and analyze in depth the company’s balance sheet. You will often find companies selling under what their assets are worth minus liabilities. Try to avoid situations where the book value has been decreasing, or the company has multiple depreciating assets. Sometimes you will find companies often in beaten down sectors that you should avoid. Where despite trading under book value, the equity value is continuously decreasing.
Not as often as stocks trading under book value, but sporadically there are stocks trading under the cash they hold. Meaning the company has more cash in its balance sheet than the stock price. Be careful with some sectors that due to their specific operations require that companies hold a lot of cash, namely the banking sector. If you can find such undervalued stocks you should research the company extensively and fully understand why the stock is priced so low. Often you will find that the market overreacts to negative news, and situations where the stocks are overly shorted and oversold can be extremely profitable situations for the patient investor. Some undervalued stocks can be bought for almost the amount of cash the company owns. This means that you will get the cash and a company for free.
Sometimes companies hold multiple investments in other companies that might offer value. 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! It requires you to analyze every investment the company owns to make sure they are fairly priced. If so you are essentially buying the company’s investment portfolio at a discount and get the company for free. Avoid situations where the investments are overvalued. It might give you a wrong perspective on the value of the whole business. Also be on the lookout companies with shrinking revenues and profits. The apparent cheap price might signal negative future prospects for the business.
Growth stocks often have a higher price to earnings, as rising expected earnings will usually lift the stock price. Despite the higher price, you can often find opportunities in sectors you are knowledgeable about that might offer great upside. You should look for companies that are growing but have lower price to earnings ratio than their counterparts, stocks where the growth might be higher than anticipated, and finally companies who become profitable. While looking at companies with lower price to earnings ratio, try to analyze them in comparison with their competitors, and ask yourself why is the p/e lower?
As for companies that might grow more than expected. You should look at sectors that are trending and what companies are operating in the space that might have a competitive advantage and might grow faster than estimated. And lastly try to look for stocks that aren’t profitable and will eventually become. This is a great way to ensure you book a great return! Mainly because when a company becomes profitable the general market usually attributes higher price. Essentially repricing the company. As analysts change their models based on positive discounted cash flows. The price of those stocks move upwards. With this in mind look for companies where management is top notch, and has been delivering results according to estimates or above.
Although much more common, there are many stocks that can be profitable situations but present a higher degree of risk. Over leverage can happen for many different reasons. Although I would advise you to look elsewhere for value there can be some very good opportunities among indebted companies. Try to understand exactly why the company has accumulated so much debt and what did management do with the capital. You should also focus on what is the management’s attitude towards the debt and how it is being repaid. Focus on 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 lower the debt faster.
M&A that didn’t go as planned
Merger and Acquisitions don’t always go as planned, and this can provide investors with great returns. A company might pay a price much higher than the value of the acquisition or it could find some challenges integrating the operational segments. When situations like this happen the stock price usually descends and you could be presented with some value stocks. Similarly to the over leveraged stocks you should look for a positive change happening. Understand why the Merger or Acquisition didn’t go as planned. You should also consider the debt, usually M&A might be done with borrowed money and it’s important to put that into perspective when considering that undervalued stock.
Commodity driven stocks
Another interesting situation that happens often are stocks driven by commodity prices, like miners and farmers. Understanding commodity price movements is incredibly easier if you compare to stock analysis. The reality is their price is mostly driven by supply and demand. Understanding how the supply and demand work, and how it is traded globally are the two main objectives. With that in mind you can find commodities that due to fluctuations in supply and demand will either rise or fall. You can then look for stocks that are driven by those same commodity prices.
The market usually prices things fairly, but 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 one of the reasons investing is so complicated and time consuming. When you do a specific trade you are going against the general consensus. Either thinking something is worth more or less. To be successful you need to accurately decide if something is worth more or less and at the same time, determine that the general consensus is attributing a price that is incorrect.
Featured image source: Catana Capital