4 ways to find undervalued stocks - which one is best?

2012-07-07 08:38 -  , Value Investing

How to find undervalued stocks?

How to find undervalued stocks? In my home country germany there are more than 1000 individual stocks you can buy. Internationally, the choice is nearly infinite. How can you manage it, to find the best and the cheapest stocks out of this huge number of possibilities?
Let’s look at some possible ways, to find undervalued stocks, together with their pros and cons.

1. Use a stock screener

There are many finance websites out there, that provide stock screeners, which enable you to search stocks meeting various criteria. For example a P/E or a P/B ratio below a certain threshold.

In theory a good thing, but unfortunately I made the experience that there is no screener available (or at least I haven’t found one yet), that meets all my needs.

I am primarily interested in small and tiny stocks. Most stock screeners have no or often faulty data for them. For US-stocks the situation shall be a bit better, but I’m not actively searching there at the moment.

The second problem is: if you screen for undervalued stocks, you have to know in detail, what to screen for. But undervaluations of stocks can appear in many forms. There are often obscure things, you didn’t expect before. If you look at a company and think about it, you may discover that fast. The human brain is built to deal with things yet unknown. Computers are not. So you are in danger to miss some really interesting things if you only rely on stock screeners.

But despite all these problems: stock screeners are a good possibility, to generate some interesting candidates for undervalued stocks.

2. Look at the losers

It is the psyche of the human being to extrapolate good as well as bad things longer into the future than they may last. Humans tend to be over optimistic and over pessimistic.

So you might take advantage of that fact. The stock price of companies facing difficult times goes down. And it is not uncommon, that it goes down further, than the long term economic outlook for the company declines.

But watch out: a sharp fall of a stock price does not necessarily mean, that a stock is undervalued. It can only be seen as a hint, that the chance of an undervaluation might be higher than normal and that it may be worth to have a closer look at this company.

3. copy the ideas of other investors

Another possibility to find undervalued stocks, is to look what other people buy. Fund managers, friends & family, famous investors like Warren Buffett or users in forums and blogs.

But who should you follow? There are too many bad stock tips in this world. If you accept all this tips and act accordingly, you can at best expect average results, probably a lot worse.
My suggestion: follow those people, whose arguments, why a stock is undervalued, you can understand. You should never buy a stock, just because another guy is buying it. But if you know people you know are good at investing, why not take their stock picks as suggestions? After doing your own homework, you might come to the same conclusions.

4. Search systematically, from A to Z

All possibilities to find undervalued stocks I mentioned for now, have something in common. You don’t start at zero. You limit yourself to a smaller selection of stocks, either selected by other people, by a computer or by past stock performance.

But why should you limit yourself? Who is best suited to decide, which stocks are worth a closer investigation, if not yourself?

So take a list of stocks, maybe from a certain country or field of business, and simply go through the list from A to Z.

You must not analyze every stock in detail. Simply look at a short company description and maybe at the results of the last years and try to decide, if this company could be worth a closer look.
If I do that, it normally takes between 1 and 5 minutes per company. Mostly I’m not interested in the price of the stock at this stage, if a stock is cheap or expensive. I only try to decide: could it be possible to form a sensible judgement about this business and its future, with an acceptable expense of time?

By the way: it is normal, that I sort out 90% or more of all stocks, when I follow this approach. More than half, sometimes three quarters or more, of the remaining ones, I sort out when I take a closer look. So all in all, only a few percantage points of a group of stocks remains in the end, that I can count as lying inside my circle of competence and would consider bying at the right price.

Despite taking only a few minutes per stock, this approach is really time-consuming if you go through large lists of stocks. For example it took me roughly estimated 50 hours to go through a list of all german stocks (Unfortunately I had to do it two times, because I realized that I focused not on the right criteria when I did it first). Is it worth to invest that much time?

Yes, I think its worth it. With that approach you have the chance to find, what no one else found before. I consider this method to be the most effective of all. Despite of being so time-consuming. Or perhaps because it is so time-consuming. There are not many investors, who do that. Especially if you concentrate on small and micro caps you may discover some really outstanding things from time to time.

And you must not do it all at once. Look at one, two or maybe ten companies per day. Over the course of years this will add up to a really large number and an ever increasing circle of competence. You will aquire a basic knowledge about a huge number of companies. That can’t be a bad thing.

Conclusion

All mentioned possibilities to find undervalued stocks have the advantages and disadvantages. I myself use all four methods. No method is perfect.
You should try all methods to find out, what suits you best.
I like the systematic search most. It is the only approach that gives me the feeling I don’t miss too many interesting candidates (although I certainly still miss many interesting things with that). And it gives me the possibility to slowly but steadily increase my knowledge about the universe of stocks.

Which is your favourite method? Have you any tips for applying these methods well? I would be happy, if you leave a comment!


Comments [4]

  1. — Kai · 2012-07-07 13:10 · #

    Acutally I use a combination of all the methods described above. Plus I put some more selection criteria up front, e.g. I do not invest in military stocks, or in stocks where I believe they are too far away from my area of expertise.

  2. CWR · 2012-08-03 16:27 · #

    My method is to select all the high quality and large companies using a basic criteria: over 1B market cap and a dividend history of at least 10 consecutive years. In the U.S. there are 1000+ of these stocks. Foreign stocks traded as ADR’s on the U.S. exchanges, there are about 200 that I have found so far.

    Since I couldn’t find any screener for the consecutive dividends, I had to search manually using google stock charts expanded to 10 year timeline and looking for the dividend symbols, then backchecking that against the company annual reports/20-F’s.

    All this work has resulted in a large list of stocks and then I track those that are undervalued ie. below book value. Now I am looking at individual company finances to see what are the good ones.

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  4. Samir · 2013-03-20 03:11 · #

    I used the method outlined here to screen for cheap stocks.

    It’s effective and has helped to make many good buys

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