If you like to pick your own stocks — or you want to start — finding undervalued ones can be one of the most profitable investment strategies. The idea is to locate stocks, of otherwise strong companies, that have simply been overlooked by the market at large. For this reason, they are selling well below the valuations of other stocks in their sector.
Why Undervalued Stocks Can Be Your Best Investments
Undervalued stocks can outperform more popular stocks because they don’t have the built-in premium that current big-hitters have.
For example, a popular stock has already had its major run-up, and will most likely do little more than keep pace with the general market. If the market rises by 10% in a given year, the stock may rise by no more than 10% or 15%.
An undervalued stock has greater potential to perform better, because it can increase in price substantially simply as a result of reaching the common valuations in its sector.
An undervalued stock can rise by 50% or more in a single year once it becomes “discovered” by the general market. What does discovered mean?
The stock is gathering recommendations by well-known investment advisors, is increasingly being added to institutional investment portfolios (such as pension funds), and may even become the newest member of the “Nifty Fifty“ (one of the “must have“ stocks in everyone‘s portfolio).
But you have to get in and invest in an undervalued stock before all of that happens, so you can ride the elevator up to incredible profits.
The Mechanics of Finding an Undervalued Stock
Finding undervalued stocks is art, not science. You want to locate possibilities by looking at the most common type of criteria. Then when you find it, that’s the signal to investigate more — but not necessarily to buy yet.
Look for one of the following indicators, and then be prepared to do deep research and dive into the company’s details.
Underperforming stocks. In every market sector there are always leaders and laggards. You want to always pay close attention to the laggards. That isn’t to say that a stock is undervalued just because it’s trailing others in it’s sector. But if the fundamentals and financials are healthy compared to it’s competitors, it might be because it’s time hasn’t come yet. You’ll want to get in before it does!
Price/earnings ratio (P/E). This is one of the first clues that a stock’s undervalued. If the typical P/E ratio in a sector is 20 and you find a stock trading at 10, you need to investigate. Again, if the fundamentals and financials are comparable to it’s competitors, but it’s not being blessed by one of the investment advisor superstars, it may be a strong candidate.
P/E growth ratio. You can determine this by dividing the P/E ratio by the company’s projected growth rate over the next five years. If the number is less than one, the company may be a strong candidate. Just be careful here: growth forecasts are expectations, not guarantees.
High dividend yield. If you find a company with a 4% dividend yield in a sector that typically pays 2%, you either have a company that’s about to go over a financial cliff, or one that’s a legitimate undervaluation. The higher dividend yield is either the result of a pending financial problem (that will lower the dividend yield) or it’s a case of a stock that’s paying an above average rate, simply because it’s currently out of favor.
High book-to-market value. A company with a book value of $1 billion and a market value of $100 million may not be a growth stock, but there’s a very good chance it could be a profitable takeover target. A competitor may look to buy the company to gain control of the assets at a bargain price. The stock price could explode in reaction to the offer, creating a nice windfall. Just make sure the market value isn’t low because one or more gigantic contingent liabilities.
Pay attention to market sell-offs. There are usually more undervalued stocks to be found after market sell-offs than at market peaks. Undervalued stocks are a relative rarity in strong bull markets, but can be quite common in bear markets. Bear markets punish good stocks along with the bad, and that creates plenty of interesting opportunities. Always keep some cash on hand, that way you can find these gems after big market sell-offs — when they’re much easier to find.
Be patient! Finding — and ultimately profiting from — undervalued stocks is a slow process. Take your time and be careful in locating legitimate investment opportunities. And when you do, be ready for them to be discovered by the rest of the market. It can take years but the returns can be spectacular.
Once you find a stock as indicated by any of the above (and there are other measures as well), you will need to look into:
- Revenue growth
- Net earnings growth
- Growth projections
- Pending legal or regulatory actions
- Significant issues with subsidiaries
- Issues with primary product lines
- Stability of management
- Contingent liabilities
- Equity growth
- Unusual geopolitical risk
A problem in one or more of these categories could be the reason for the low stock price, making the stock unable to qualify as undervalued. But if all of the above check out, you may have found a winner.
Even better is a problem with any of these that has recently been resolved. It could be that the stock was depressed by the issue, and now that it’s been remedied it will simply be a matter of time before the market welcomes the stock back into the winners circle. That’s a classic example of an undervalued stock!
Online Resources to Make Undervalued Stocks Easier to Spot
The internet is both friend and foe when it comes to finding undervalued stocks. It can slim the list of available undervalued stocks because everyone has access to the same information, and truly undervalued stocks can literally become popular overnight.
At the same time, you can also find internet tools that help you discover the stocks, making the job of doing so, much quicker and easier.
You can pay any amount you want for tools that help you locate undervalued stocks. There are also a few out there that you can use for free.
Have you ever tried to invest in undervalued stocks?
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