Everyone likes getting something for less than it's worth. There isn't a person out there who says to him or herself, "You know, I would actually rather pay more for this item than what it's listed for." Yet for some reason this doesn't always translate to stocks. When the share price of a company is on a tear, many investors want to grab shares immediately because they fear the stock will never go down. Conversely, that very same company's share value could drop by 20%, and instead of saying "YES! It's on sale," these investors pull out their money, realize a loss, and lick their wounds.
If you are a bargain hunter, then perhaps buying undervalued stocks is the strategy for you. For many years great investors have been turning undervalued stocks into amazing returns for themselves and their investors, and with the right mind-set you could use those same techniques. So let's look at the case for buying undervalued stocks, along with some quick tips to get you started on searching for these companies.
Why invest in undervalued stocks?
There are two trains of thought when it comes to the stock market. The first is what is called the efficient market theory. This posits that all of the information available on a company is baked into the price of its stock, and that the value of the underlying asset -- in this case the company -- is exactly what the stock market says it is at that moment. Basically, this theory says you can't beat the market by buying individual stocks because market value is always equal to intrinsic value.
The second train of thought is that the efficient market theory is a load of bull plop. If all investing were done by robots that could buy and sell stocks completely devoid of perspective and emotions then perhaps the efficient market theory would make sense. However, people, not robots, are buying and selling those stocks, and people are always at risk of giving into emotions that can obscure rational thought. Also, people can have wildly differing opinions on future outlooks, which mean that one person can value stocks quite differently than another.
When you add the human element into investing, undervalued stocks can appear. Perhaps it's a group of investors overreacting to bad news that might not tangibly impact a company's ability to generate profits over the long term, or perhaps it's a gross misunderstanding of a company's market potential. In any case, the human element of investing suggests there will be times when the value of the underlying asset appears to be worth more than what the market says.
If you need evidence of the power of investing in undervalued stocks, just remember names like Warren Buffett and Seth Klarman. Since you are reading an article about undervalued stocks it's safe to assume you have heard of Buffett. His investing strategy as CEO of Berkshire Hathaway and its preceding partnerships -- which Buffett used to buy undervalued businesses -- is a long-term testament to the power of investing in undervalued stocks.
You may not necessarily have heard of Klarman, but, like Buffett, his investment focus on identifying undervalued stocks allowed his investment group, Baupost Group, to post a 17% annualized return since 1983, about double the performance of the S&P 500 over that time. Also, if you can get a copy of his book, Margin of Safety, it's worth a read -- although I'm not going to recommend you buy the book on Amazon.com for the lowest available price of $1,800.
These two investors are pretty much living proof that the efficient market theory is grade-A hogwash, and those investors who can look beyond the news of today and focus on what the underlying asset is worth can also benefit from buying undervalued stocks
How to invest in undervalued stocks?
Investing in undervalued stocks -- or, as it is also known, value investing -- takes one thing more than anything else: the ability to check your emotions at the door. Buffett, Klarman, and other value investors have succeeded because they can dispassionately look at a company from multiple angles without preconceived notions or emotional responses. I'm not saying it's easy to do. Rather, deactivating the emotional side of your brain to evaluate a company when so many people are doing the exact opposite is a rare quality. If you can do it, though, the rewards can be rather large.
While there is no one-size-fits-all blueprint for identifying undervalued stocks, a few things normally stand out among these companies. Many of these traits are highlighted in the book The Intelligent Investor by Benjamin Graham, which is the gospel to many value investors. According to Graham, here are some of the qualities a "net enterprising investor" should look for:
1. Financial condition: (a) current assets at least 1.5 times current liabilities, and (b) debt not more than 110% of net current assets (for industrial companies)
2.Earnings stability: No deficit in the last five years
3. Dividend record: Some current dividend
4. Earnings growth: Last year's earnings more than those of [six years ago]
5. Price: Less than 120% net tangible assets
These five things are in no way the smoking gun for an undervalued stock. Sometimes companies are undervalued for reasons such as being in an industry in structural decline or having a management team that focuses more on itself than its shareholders. That being said, the elements cited by Graham -- particularly those on financial condition and price -- can help weed out a large portion of companies and help to narrow your search for a truly undervalued stock.
What a Fool believes
There is no tried and true method to investing in the stock market. Heck, if you look at the stock-picking records of some of the great investors, you will find that there are certainly more ways than one to beat the market. Buying established, well-run companies when the rest of the world is acting irrationally has proven to be one of the most effective ways in achieving that market-beating portfolio, but it normally takes an ability to look beyond what everyone else is thinking at the time and being willing to wait for the right opportunity to arise. As Warren Buffett said of investing -- although it holds most true when buying undervalued stocks -- "In investments, there's no such thing as a called strike ... [t]he only way you can have a strike is to swing and miss."