How to Pick an Undervalued Stock Before It Picks Up Steam

Buy low, sell high. It sounds simple, but it can be easier said than done.

In this clip of Industry Focus: Healthcare, Motley Fool contributor Todd Campbell and analyst Kristine Harjes explain how to look at cheap stocks in the healthcare sector, what ratios and numbers to look for in a company's balance sheet, what background info you need to know around the industry before you buy, and one example of an undervalued pick that might be a great long-term investment.

A full transcript follows the video.

This podcast was recorded on Dec. 21, 2015.

Kristine Harjes: So, Todd, what makes something a good bargain, if it's not just low share price?

Todd Campbell: People have to look at it -- I love how you just summed that up, by the way. That's fantastic. It's like a Black Friday sale, where you just bought something at 25% off the price. You're getting a great deal on it. It's a fantastic way of looking at it. And I think people need to approach the stock market the same way.

If a stock gets down to $5, there's probably a reason that other people don't want to own it. What you need to look at is, "What is the company's current product demand? Are they raking in sales? Are their sales growing? What's their profitability? Is it growing? Are their earnings growing?"

And then, you have to say, "What do I think the future looks like for this company? Will demand continue?" So, you're considering a few different things. When you start looking at cheap that way, you start saying, "OK, what can I buy as far as companies out there that are growing and doing well and not have to pay a lot of money in terms of price-to-earnings ratio, how much the share is divided by earnings per share that's expected, forward earnings." When you start looking at it that way, you find plenty of bargains that you can throw in the stockings.

Harjes: Yeah, this forward P/E metric is a really handy way of saying, "Oh, wow, this stock is a bargain." Of course, there's more to it. You want to really dive in and do your research. Seems a good time to throw it out there that, as always, people on the program may have interests in the stocks they talk about, Motley Fool may have formal recommendations for or against them, so do the research, don't buy or sell based just on what you hear today. And, in doing that research, definitely check out the forward P/E ratio.

So, in this episode, we're looking at 2016 earnings, and the multiple that a couple of stocks are trading at for 2016 expectations. One that stood out to us, and this is no surprise, we talk about this company all the time, Gilead Sciences (GILD 0.07%) trading at 8.66 times its 2016 earnings expectations. That's pretty cheap. But why? Why is that number so low?

Campbell: This is a stock that you could argue is mispriced because people have continually bet against it for the last year by thinking that competitors would come out and launch drugs that will challenge its leadership in the hepatitis C indication, and that that money would therefore disappear from Gilead's revenue and profit stream, head to these other competitors.

That has not happened. Viekira Pak was a drug that was approved by AbbVie that launched in January. Sure, it's going to do a couple billion in sales, but last quarter alone, Gilead Sciences' two hepatitis C drugs were on pace to deliver more than ... I think the annualized rate, almost $20 billion annualized, exiting Q3. 

So, yes, there's competition, and we have to be aware of that competition, and there's some new competition coming. Merck & Co. has PDUFA date coming up, an FDA decision date coming up early next year. But few companies have been able to do a better job at insulating their market share against competition than Gilead.

They've done it for years in HIV, they're already starting to demonstrate that they had similar success here and hepatitis C, you've got a cheap company on forward price to earnings because people don't think they can continue to deliver the revenue and earnings that they have been. And I think that might be creating an undervaluation that investors can take advantage of.

Harjes: Yeah, I think as soon as Gilead can finally prove that they can overcome these competitive threats, which they have already shown time and time again that they can. But there remains this doubt in the market. So, as soon as people start to have faith in Gilead, which I certainly think is coming down the pike, that's when you should see, hopefully, the stock appreciate and become a great buy if you get it now.

Campbell: You look at it and say, "What's a fair price for this? Is it less than nine times forward earnings? Or maybe it's 12? Or 15?" So then, if you take that $11, say, in 2016, and you put a multiple on it of 12, you can get a pretty good idea how much upside opportunity there could be for this company. And that's just if they can hold on to the market share that they have now. It doesn't have anything to do with their other efforts to try and expand into other indications.

Harjes: Yeah, this is a company with a very deep pipeline.