The key to investing success is to “buy low and sell high”. So it is pretty simple, you just need to find undervalued stocks, hold them until they rise in value, and then sell them.
But this first part is as difficult in practice as it sounds easy in theory. So this article will go back to the basics. We’re not looking at specific companies, we’re looking at proven strategies for finding undervalued stocks and how to implement them successfully.
This is a central tenet of value investing, and growth investing as well. The difference is that value investors want the current value to be underestimated by the markets, while growth investors look for an underestimated future value.
Picking the Right Value Metric
Value investors have always focused on calculating financial metrics to determine which stocks are undervalued.
Some of these metrics preferred by Benjamin Graham are familiar to most investors, like the P/E ratio or positive earnings, or a good dividend yield. Others might be less familiar, like price to book value, current ratio, or debt to current assets ratio.
👉 What these ratios have in common is that they paint a picture of the company in 2 dimensions:
- Risk: debt level, and current assets available will determine if a company would go under after just a few bad quarters. Higher risk makes a low valuation meaningless.
- Profitability and returns to shareholders: if the risk is acceptable, the company needs to be priced cheaply compared to its profits. It is also best if shareholders’ interests are taken into account by the company’s management.
Such metrics have been used to find the elusive “margin of safety”, which is so dear to great investors like Seth Klarman (follow the link for his full profile).
These ratios are useful but are less powerful than in the 1930s when Graham first wrote about them. This is because back then, they had to be manually calculated, and data had to be found on print first.
Internet databases and algorithmic comparators changed that. Now, a few dollars-a-month subscriptions can allow you to create a screener for any set of “value” indicators you can think of. As this tool became more widely used, the easy pick of “net-net” that made Graham rich became almost extinct. When everyone has access to the same information at the same time, it’s hard to use the information to gain a meaningful advantage.
Valuation ratios are still important, but you can’t expect them to tell you anything that the rest of the market doesn’t already know.
The Macro Method
Stock picking is usually bottom-to-top. You find a potentially interesting company and look at its financials, and then at its industry and competitive position.
Another option is to start from the top. The idea is to find an entire segment of the economy that is undervalued or predict an important event that will affect the market massively, like a change in interest rate, a banking crisis, a war, etc…
The strength of this method is that it can be easier than finding a company that is undervalued. Sectors of the market are often undervalued or overvalued in turn, so there is virtually always one or several large undervalued sectors at any time.
The issue with that method is that it requires the ability to completely ignore the consensus when it is wrong. This can be rather psychologically taxing and hard to do in practice.
Timing will also be an issue. As the saying goes, “Markets can stay irrational longer than you can stay solvent”. You can watch the movie The Big Short to see this problem in action, portraying the struggle of Michael Burry for his correct but early analysis of the 2008 real estate bubble (and Burry profile here).
When the approach is using an event-driven macro bet, it can get even more difficult. “Certain” predictions often fail. Irrationality can dominate the market, and international affairs and central bank policy are absurdly hard to predict correctly.
So while potentially very lucrative, this is also a strategy that can lose a fortune, and where humility will pay off. The ability to realize you are wrong soon enough is crucial here, as admitted by masters of this approach like George Soros or Stanley Druckenmiller.
📚 For more detail about this method, you can read our article on the topic: Investing in Hated Sectors: Finding Value in Unloved Stocks.
The Quality-Driven Approach
We mention that the obvious bargains based on financial ratios have become harder to find as information becomes more widely available.
This was a problem for a disciple of Graham, a man you might have heard of in investing circles: Warren Buffett. Partially under the influence of his partner Charlie Munger, he started instead to focus on the quality of a business above price.
Or, as he put it, “A wonderful business at an okay price is far preferable to an okay business at a wonderful price“.
The reason quality tends to outperform other approaches is that, over time, it dominates total returns. The initial purchase price is of little importance if a stock compounds by 25%+ yearly for decades, like, for example, Coca-Cola did for Buffett.
This has been a truly amazing method, and one used by many “super investors” in one form or another, depending on their perception of what defines “quality”.
The difficult part here will be to develop the right temperament, a mix of extreme patience, confidence, and humility all at once.
Riding An Exponential
Some trends are bound for an upward trajectory. The internal combustion engine and radio in the 1930s. Microchips in the 1970s. The Internet in the 1990s. Social Media and e-commerce in the 2000s and 2010s.
In the same way that an undervalued sector will see all companies in that field rise at some point, technological revolutions can make a fortune for early investors.
The key is to correctly identify new technology, and distinguish revolution from fads.
For example, there was a bicycle investing bubble in the 1890s. A flood of new manufacturers broke the market and made no money. Bicycles are still around, but they are hardly money-makers for investors. Beauty and health products using radioactive radium were all the rage in the 1920s.
Another caveat is that most “revolutions” go through a bubble stage, like the dot-com bubble in 2000. No matter how important technology will be in the future, there is a point where valuations are too high, and a 60%-95% crash is likely. So most growth investors using this method will need to know when to leave for greener, safer pastures.
👉 The poster child of such an approach is certainly Cathie Wood, with all the upsides and risks it implies.
Using a Unique Advantage
The last option is to use unique knowledge or insight to spot an undervalued company. At a glance, this might seem reserved to experts, like engineers, scientists, or maybe bankers.
It is actually accessible to most people. A housewife will know more about baby products than most specialized marketing analysts. A painter or a plumber will know the quality of brands they use every day better than any hyper-specialized Wall Street analyst. A videogame geek probably knows minutes after a new game release is announced if it will sell well, judging from the reactions of the fans.
This is an approach that can also be combined with the other. For example, Buffett is famous for having stayed out of technology stocks for decades, just because “he did not get it”. He preferred to stay in his “circle of competence” like insurance and consumer goods. A traveling salesman might know perfectly which ERP or CRM software is popular in his industry.
👉 A great teacher of this method was Peter Lynch, in his popular book “One Up On Wall Street”.
Finding undervalued stocks is probably the most fundamental key to outsized investing success. And it should not be hard in theory. The problem is often that people try a little bit of everything. Instead, they should understand that great investors were always experts at one or two methods.
👉 So the best way is for investors to find what “click” the best with them.
- Are you passionate about history and economics? Then a macro approach might make sense.
- Are you very patient and unlikely to be swayed by stock price fluctuations? Then a long-term, quality-focused approach is probably for you.
- Do you have a unique insight about a specific field because of your job, hobby, or interests? Then Peter Lynch’s method is something you should learn more about.
None of these strategies will find undervalued stocks on their own. You will still have to execute the strategy, and that takes discipline and hard work. Choosing a strategy is still an essential first step.