The Investor’s Goldmine: Strategies for Finding Undervalued Stocks

Key Takeaways

• Value investing generally works best for those who want to hold their assets for the long term, since value businesses may take years to scale.

• While value investing over time has produced top-shelf returns, there have been periods during which growth investing – seeking stocks with strong upside prospects – has performed better.

• Value investing is partly based on the notion that the market is not entirely rational, and thus can provide opportunities to profit from discounted stocks.

For most investors, the name of the game is finding a strategy that works best for them, accounting for factors such as long-term financial goals, risk tolerance, capital access, and investing style.

The good news for investors is that approaches are flexible. If one strategy does not prove to be a good fit, or one’s circumstances have changed, the investor can pivot. Note that there may be tax considerations involved with the approach change, however.

Here, the focus is on value investing, which involves finding undervalued stocks and later selling them at a profit, and what investors should know.

What are Undervalued Stocks?

These are stocks that are selling at a price that is substantially less than what is assumed to be its intrinsic value. For example, a stock that sells for $60 but is worth $120 based on expected future cash flows is an undervalued stock.

Such a stock can be assessed by reviewing the company’s financial statements and studying fundamentals such as profit generation, return on assets, and cash flow.

By comparison, a stock is considered overvalued if it sells for more than its perceived value. 

Factors that Lead to a Stock Being Undervalued?

There are a number of reasons why a stock can be considered overvalued, which an investor may want to consider:

• Diversification. Companies that find new markets, goods, or services can have undervalued stocks, which a savvy investor can pick up on.
• Deflated market. When the overall market is down, the value of a number of shares will come down as well.
• Cyclical actions. The valuation of a company’s shares is defined by profits. Thus, a drop in sales can cause a stock to become undervalued. The obverse is also true.
• Non-trendy stocks. Investors generally tend to be attracted to leaders in trending sectors. At the same time, well-established companies in sectors that may not be “on trend” but have sturdy fundamentals do not garner as much attention. 
• Herd mentality. When the market’s general momentum is high, investors clamor to purchase shares. Then, they sell them when the market declines. This causes shares to become undervalued.
• Bad reputation. If the media have gotten hold of a company’s misfortunes, that company’s stock price will drop. When this happens, traders should evaluate whether the company is strong enough to rebound.
• Low-debt stocks. Because steel, power, and infrastructure companies commonly have significantly high debts, value traders generally stay away. Companies that have minimal debt and consistent growth that is reflected in profits frequently carry undervalued stocks. While there are no guarantees, the future prices of such stocks are likely to rise.  

Key Metrics to Consider When Looking at a Stock

There are a few primary metrics to look at when considering a stock, including:

• Price to earnings ratio. This ratio will show the share price relative to the earnings portion due the share from the equity capital the company raised. A high ratio means the stock price will be more, relative to profits derived. On the other hand, a low PE means more profits against the share price paid. To maximize profits, investors may want to seek out companies with low such ratios.
• Price to book ratio. This is the ratio between the company’s price per share and its book value. It indicates the company’s financial strength and whether it can profit in the future. 
• Debt to equity ratio. This ratio indicates the relative proportion of shareholders’ debt and equity used to finance company assets. The optimal ratio tends to vary by industry.

Value Investing Strategy

Those who engage in this approach are seeking stocks they believe are undervalued. In essence, they are bargain shoppers on the hunt for stock prices that, in their estimation, do not wholly reflect the security’s intrinsic value.

Value investing is partly based on the notion that the market is not entirely rational, and thus can provide opportunities to profit from discounted stocks. Because such assets may be bought at a comparatively low price, the investor hopes to improve their chances of a return.

Rather than pour over reams of financial data to locate deals, investors commonly use the thousands of mutual funds that can give investors an opportunity to possess a volume of stocks believed to be undervalued.

Other investors prefer to use the price-earnings ratio – a stock share divided by the company’s earnings per share – to find cheap or undervalued stocks without conducting exhaustive research. They search for companies with a low P/E ratio, which indicates the investor is paying less per U.S. dollar of current earnings.

Principle of Value Investing

Value investing is based on the principle that the market can sometimes misprice securities, resulting in opportunities for them to be purchased at a discount and sold at a profit after increasing in value. 

Within that principle is another one: the margin of safety. With this important principle, the investors buys stocks when market prices fall under their actual value. Purchasing securities during this margin can help to mitigate risk.   

Contrarian approach

This strategy assumes that the market frequently overreacts to unfavorable news or occurrences, resulting in the overselling or undervaluing of assets.

Contrarian investors generally hew to the idea that the market will ultimately acknowledge the assets’ true value, causing the price to rise, and producing major profits for the investor.

Long-term vs. Short-term Perspective

Value investing generally works best for those who want to hold their assets for the long term, since value businesses may take years to scale. This kind of investing takes a longer view. Consider Warren Buffet, whom many consider the ultimate value investor. Upon making a significant investment in the airline industry, he famously said that while airlines had sustained a “bad first century, they got that century out of the way, I hope.” 

While value investing over time has produced top-shelf returns, there have been periods during which growth investing – seeking stocks with strong upside prospects – has performed better. In fact, there have been three such periods over the last 90 years, according to a Dodge & Cox study. Those decades included the Great Depression (from 1929), the Technology Bubble (1989), and the period largely from 2004 to 2014.

Benefits, Considerations, and Risks

As with all other investment strategies, there are advantages and possible drawbacks to value investing.

For one thing, it is not guaranteed that an undervalued stock will appreciate, and even if it does, it is unknown when that will happen.  In addition, there is no precise way to establish a stock’s intrinsic value. In fact, such values are subjective and based on perception.

The belief that a stock is priced too low is based on current indicators like those utilized in a valuation model. If a company’s stock is priced significantly less than the industry average, it may be deemed undervalued.

In a nutshell, here are value investing’s benefits and drawbacks: 

Benefits

• Because they are not as dependent upon cash for growth, value companies are more apt to issue dividends.
• The roots of value investing are in basic analysis and commonly backed by financial tools.
• Value companies frequently have more formidable risk/reward relationships.
• As a company’s actual intrinsic value is fully realized by the market, opportunities for big gains manifest.

Considerations

• Portfolio diversification is diminished by investing exclusively in underperforming sectors.
• Long-term holding does not guarantee success, as the company’s fortunes may take an even worse turn.
• This kind of investing requires more patience than many investors want to demonstrate, as successful value investing takes time.
• Value companies can be challenging to identify, particularly considering how accounting practices can inflate earnings.

Investing Beyond the Stock Market: Finding Undervalued Alternative Investments

Those who seek to invest in undervalued assets might wish to consider looking outside the stock market.

Seeking refuge from stock market volatility, retail investors increasingly are turning to “alternative” assets – those other than stocks and bonds. The market for such asset classes, which include real estate, art, cryptocurrency, and transportation, among many others, is expected to reach $14 trillion through this year, according to data intelligence provider Prequin.

The investment platform Yieldstreet is responding to such heightened interest with the broadest selection of alternatives, many of which have potential for long-term growth. Because the offerings are highly curated, Yieldstreet can uncover undervalued opportunities for the investor.

In addition to prospects for regular secondary income, alternatives serve the important purpose of diversification. To mitigate overall portfolio risk, and protect against inflation, it is vital for investors to have holdings that combine varying types of assets to reduce chances of experiencing large losses.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Alternative Investments and Portfolio Diversification

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Investors who understand the characteristics of common investing strategies, including value investing, will be better positioned to adopt one that suits them over the long term.

While opportunities do abound in undervalued stocks, that is also true for alternative assets, which also serve to diversify portfolios.