Finding undervalued stocks can be easy if you know what to look for and how to invest for the long-run
Besides looking for dividend stocks, value investing has got to be my favorite investing strategy.
You see, I’m a cheapskate at heart and nothing appeals to me more than finding an undervalued stock ready to bounce back.
I hold all my investments for years, usually for decades, so I’m not looking for a quick profit but it sure does feel good to see that double-digit positive return next to each stock in my portfolio.
But value investing isn’t without its risks and investors have been disappointed over the last few years as growth stocks seem to be taking over market leadership. Ironically, people may be dropping value stocks at exactly the wrong time.
I’ve put together this value investing guide to walk you through everything you need to find undervalued stocks and how to avoid the risks. I’ve included the criteria I look for in value stocks as well as a strategy that nearly guarantees you’ll make money with your investments.
What is Value Investing?
Value investing is one of two major investing strategies. Investors look for companies that are priced below a fair price estimate or relatively inexpensive compared to peers in the same industry.
The idea is intuitive, buy shares for less than what they should be worth and wait for the rest of the stock market to see it your way. Value investing would seem to be the ultimate buy low, sell high strategy.
Value investing contrasts with growth investing where you are buying stocks with strong expectations for sales and earnings growth into the future. Growth stocks may seem to be overvalued on some of the measures we’ll talk about but the idea is that faster growth will continue to push the share price higher.
The difference between value investing and growth investing can be summed up like this…value investing is about looking into the past while growth investing is about looking into the future.
Finding undervalued stocks usually starts with a few fundamental measures, metrics found from the company’s financial statements or provided by online investing websites.
- Price-to-earnings ratio is the stock’s price divided by the amount of earnings per share over the last year. Probably the most popular metric, it is how much investors are paying for every $1 in earnings.
- Price-to-sales ratio is the stock’s price divided by the sales per share generated by the company. A lot of accounting gimmicks go into creating earnings so I like to use sales as a value measure because it’s more difficult to manipulate by management.
- Debt-to-equity and other measures of debt are extremely important because high debt levels can destroy a company’s ability to get out of financial trouble.
Beyond these three value investing metrics, you can compare other measures like sales growth and profitability.
The most important rule for value investors, and really anytime you are picking stocks, is to always compare stocks within the same sector and industry. A sector is a large grouping of companies that make a related product, think companies that make consumer goods or financial companies. An industry is a smaller grouping of companies within a sector that make a very similar product or serve a similar product demand.
The reason why you always need to compare stocks within a sector is that those fundamental metrics vary greatly depending on the sector. A low P/E ratio for stocks in the technology sector would be very high compared to the average in the financials.
- Some sectors and industries typically see faster growth and investors pay a higher price premium in price/earnings.
- By virtue of stable sales and earnings, companies in some sectors can manage much more debt because they know they’ll be able to make payments.
So you see, comparing simple measures like P/E and debt levels in stocks of different sectors can skew your perception of value. Just looking for low P/E stocks is going to fill your portfolio up with stocks from a few sectors like telecom, financials and utilities while there might be some great undervalued stocks waiting in other sectors.
Undervalued Stocks versus Growth Stocks
Investors make money on growth stocks just as well as they do value investing. There are risks to both strategies.
Value investors are betting future sales and earnings will look something like the past and that the stock should be priced higher. Growth investors are betting on future sales and earnings to be much higher than present, rationalizing a higher price today.
I prefer value investing because I think it’s the less risky strategy.
Investors are optimistic almost by definition. They are investing their money, betting that a company’s earnings will provide a return in the future. This bet can easily get out of hand and investors can start expecting huge earnings growth to justify a high price for a stock today. Eventually those growth expectations get ridiculously out of touch with reality and growth investors get crushed.
Granted, value investors are betting that a company’s future will look something like its past. This might not be the case if the competitive environment has changed or the company isn’t able to recover from whatever is holding back its share price…I just have a lot more faith in pricing an investment off what’s happened in the past versus trying to predict the future.
Stock Market Returns for Value Investing
Value investing provided solid returns for decades until the financial crisis. Value stocks in the Russell 1000 Value Index grew by an annual 16% over nearly three decades through 2008 – and that’s including the massive crash when the housing bubble burst.
In fact, stocks of undervalued companies beat an investment in growth stocks by 161% over the period.
Value investing seems to have lost some of its appeal with investors since 2009. Super-low interest rates have made it easy for companies to use debt to fuel growth and to buyback shares. That has helped growth stocks outperform for nearly a decade though value stocks have provided a respectable 12% return over the period.
Value investing isn’t dead and it might be the best decision you make with your money going forward. Interest rates are edging higher and the bull market, now the second longest in history, is looking especially weak.
There will be an economic recession, probably within the next couple of years, and growth stocks are going to get hammered when investors realize those high expectations will not be met.
Value investing is your best chance to protect the money you’ve earned and for strong returns in the future.
How to Find Undervalued Stocks
Picking undervalued stocks boils down to following a few fundamental measures and then looking a bit further into a company’s business to find good long-term investments.
It’s really not as difficult as a lot of advisors make it out to be and you don’t need to be a stock market guru.
It starts with a simple stock screener to find a few potentially undervalued stocks. I’ll walk through the stock screener I use before getting into a guaranteed strategy for buying undervalued stocks in the next section.
I’m using the stock screener on my Ally Invest account but most online investing sites offer a similar screener. I like Ally because of its low $4.95 per trade fee, deep market and stock research and investing tools.
- I usually only look to large- and mega-cap companies for value stocks. I want to make sure the company has the financial size to survive any short-term shocks that are causing the shares to be undervalued.
- When searching for undervalued stocks, you absolutely have to do it by sector or industry-level. What is undervalued in one sector, i.e. a low price-earnings ratio, may not be in another sector. This means screening through each individual sector to find potential value stocks.
- Setting your price-to-earnings and price-to-sales cutoff when screening is just to get a group of potential stocks. You’ll be able to see the actual numbers for each stock when you click ‘View Matches’ and will be able to see how undervalued each is on the different measures.
- Dividends isn’t a requirement for investing in undervalued stocks but I like to get paid while I’m waiting for a rebound in the share price. I’m a big fan of dividend stocks and include it in just about every screener I use.
The stock screener updates automatically with how many stocks match your criteria, a great feature to help adjust your criteria so you see a few stocks in each sector. Once you’ve narrowed the list down to a handful of stocks in each sector, you can look further into each sector and each stock.
The Ally stock screener also comes pre-loaded with six stock screens to find investments in other themes like dividend stocks and growth stocks.
Looking at individual stocks involves more comparison as well as a little financial detective work. Go through your list of undervalued stocks first to compare all the valuation measures with the industry. This is fairly easy with Ally Invest because it shows you exactly where the company is versus the industry average.
Some of the fundamentals I look at before picking undervalued stocks include:
- Price-to-earnings and Price-to-Sales – Earnings can be manipulated with accounting gimmicks so always look at another factor, like sales, when trying to find stock picks.
- Debt-to-equity and other debt measures are extremely important in value investing. Too much debt will limit the financial flexibility to survive so you want to avoid companies that owe too much compared to peers.
- Return-on-Equity and Return-on-Assets are good measures of management effectiveness to watch. A well-run company can rebound from a crisis if it has good management and not too much debt.
You also want to look at the company’s sales over the last few years and the trend in operating margin. Operating profit is the money left after paying all normal business expenses. The operating margin is just that profit divided by sales to see how well management is doing at creating value.
Your goal is to find why the rest of the stock market is discounting the price of the stock. Why is this stock seemingly undervalued compared to competitors? You may need to read through company news and a few analyst reports.
When you’ve found the ‘reason’ the shares are undervalued, you can ask yourself whether it is a temporary problem or one that could bring the company down. If the company’s size, brand quality and financial flexibility will help it survive and eventually recover then it could be a great investment.
Some other points I like to look for in value stocks:
- Factors that are affecting the entire industry that are weighing on a stock. You can’t blame a single company for big, industry-wide problems and the leaders within a group will always recover.
- Government oversight or consumer outrage over a product can cause price-plunging headlines but the long-term affect is often minor. Look for stocks that are the recent scapegoat but have strong financials to survive and thrive.
My Guaranteed Strategy for Buying Undervalued Stocks
The biggest risk in value investing is that the stock price just keeps sinking lower. You’ll often hear investors talk about, “trying to catch a falling knife.” It’s the idea that investing too early before a stock has stopped falling can cut you bad, leaving you bleeding money from your portfolio.
It’s true that value investing can be risky but no more so than growth investing. Investing in growth stocks means you take for granted all the pie-in-the-sky assumptions for future sales and earnings. When those assumptions don’t pan out, your shares can sink to zero.
There is one thing you can do to almost guarantee your value investing strategy…keep investing!
If you are investing in solid companies with long-term potential and not burdened by debt then the share price will eventually rebound or the stock will become so cheap that another company offers a buyout.
If you invest regularly in a company, even as the share price falls, your average price for all the shares decreases.
- If you buy 100 shares at $23.50 and
- 100 shares at $19.60 and
- 100 shares at $18.15
Your average cost for the 300 shares equals $20.42 per share. That means the stock only needs to come back up to that point for you to start making money.
I know there are plenty of examples of stocks that went all the way to zero, bankrupted companies that pulled investors all the way down with them. That’s why it is so important to look at debt when investing in value stocks. Even a company with weak sales growth and low profits can recover if it doesn’t have so much debt as to sink the ship.
If you are going to be a value investor, you absolutely must pick companies with long-term business potential and low levels of debt.
Best Undervalued Stocks to Buy Right Now
I don’t usually talk about individual stocks on the blog because they might not be the best choices when you find an article. What is undervalued when I post the article may not be a good value pick when you find the article through Google or in the blog’s archives.
But I will look at a few value stocks here, not as specific recommendations but to show you my thought process for finding undervalued investments. You’ll get an idea of the fundamental information I looked at as well as why I chose some of the stocks over other picks.
Shares of drug makers have suffered over the last year on fears that the government will start regulating prices. That means even good companies like Teva Pharmaceuticals (TEVA) have plunged into value stock territory.
Even if the government takes a stronger role in drug pricing, aging demographics in nearly every developed nation means drug makers are looking at decades of increasing demand. Teva is a primarily a generic drug company which means it benefits from all the R&D spent at other companies and prices don’t usually draw as many headlines.
The drug maker’s shares trade for just 1.4-times sales booked over the last year, nearly half the average 2.5-times sales for the industry and well below the stock’s five-year average of 2.1-times sales. The company took on quite a bit of debt for its purchase of Allergan’s generics business last year but still has a debt-to-equity ratio around the industry average and easily covers its interest payments.
Hanesbrands Inc (HBI) has been hit this year with the rest of the apparel companies and retailers. As more people shop online, traditional retail stores are finding it difficult to compete. While the verdict is out on a lot of the stores you typically see at the mall, Hanesbrands has a strong brand name and sells a product everyone needs.
Hanesbrands has been building its online sales channel but is also sold through many physical stores. It doesn’t have quite the same problem as, for example The Gap or Abercrombie & Fitch that only sell their branded clothes through their own stores.
Hanesbrands has a strong manufacturing network with 52 facilities across the globe, balancing low-cost manufacturing with distribution. The shares trade for 15-times earnings versus an industry average of 21-times and the company’s own five-year average of 23-times earnings.
Again, these two stock picks aren’t recommendations but just an example of what I look for in value stocks.
- Shares that are relatively cheaper than industry peers on a price-sales or price-earnings basis.
- Companies without too much debt that could keep them from being able to survive short-term drops in sales or earnings.
- Companies with long-term upside in sales and brand names that people trust, but that have been thrown out with other stocks in their industry on recent news.
Value investing is one of my favorite strategies for long-term investing. It really isn’t difficult to find undervalued stocks but you do need to know what to watch for and be ready to hold on for years while the stock price rebounds. Put these stocks in your retirement accounts and benefit from decades of solid returns without the risk in growth investing.