“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
– Warren Buffett
The wisdom here is that the focus should be more on the company itself than on the price of the stock. Not to say price is irrelevant. But Buffett is emphasizing that a good price on a stock of a bad company is still a bad idea. What you want to look for is a good company and then buy it when the stock is priced well. Following this form of investing can help to protect a portfolio of stocks from falling victim to “bubbles and crashes”. Another one of Buffett’s famous quotes is to only purchase a company stock that you would want to hold if the market were to close for 10 years.
You’ve probably heard of investors who’ve purchased a stock at just the right moment – when prices were low – so low that it seemed like the business might be failing – only to have it increase in value practically overnight. The result? That investor is now rich. While this scenario is quite rare, it does happen and it’s most likely because the stock was undervalued.
Here’s what you need to know about undervalued stocks and if this kind of investment is right for you.
What Exactly is an Undervalued Stock?
An undervalued stock is one that is selling at less than its intrinsic value. Wikipedia defines intrinsic value as the value of a company [stock, currency or product], determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. The fundamental value of a stock can be determined by analyzing or calculating the return on assets, capital management, cash flow, and profit retention through the company’s financial statements.
Why and When are Stocks Undervalued?
As Investopedia points out, there are several reasons why a stock might be undervalued sometimes, two or more of these situations can be at play at the same time. They include:
Most businesses go through cycles of higher and lower profits. This could be due to something as benign as the time of the year. For example, a company that sells lawn equipment is likely to see lower profits during the winter months and higher profits in the summer.
Many people invest based on market momentum and following what other investors are doing. During a rise in the market or as a company’s stock price increases, investors tend to buy. This behavior is partially fueled by their belief that they’ve already missed out, as well as their desire to “get in the game”. Now they want to position themselves to reap future gains by purchasing a stock that might be trading above its intrinsic value just to feel like they are “in the know”.
This same phenomenon also applies when a stock’s price is falling and/or when the market itself is declining. Investors start to fear that they’ll lose everything so they rush to sell. Rather than waiting for the market to go back up – as it inevitably will – they would rather sell their stocks at a loss. This behavior is so prevalent that it can amplify any downward movement in the market.
We all know them, those stocks with a status attached to them – the ones you must own. But, what about an unglamorous stock that’s well established in its industry? If you took a poll and asked investors if they’d rather invest in Google or Johnson & Johnson, most people would choose Google. Not only is Google a leader in the trendy technology sector, it’s also in the news far more often than Johnson & Johnson who makes consumer goods.
Bad press detailing a company’s setbacks almost invariably results in their stock price declining. Rationally, this effect doesn’t make sense because all companies have setbacks that they must overcome. A single recall or litigious event doesn’t mean that the company is on a downward spiral or that it’s no longer valuable.
A stock that stays under the radar because it’s not a well-known name or because it’s not in the news can easily become undervalued. Foreign stocks and small cap stocks are two examples of stocks that typically go unnoticed by investors.
Market Bubbles and Crashes
When investors tap into the herd mentality and market momentum too deeply, panic can ensue and cause a crash. The Wall Street Crash of 1929 that sparked the Depression is a prime example. This kind of behavior can also fuel stock market bubbles, where overinvestment drives the price of a stock so high that its fundamentals can’t support the price. Inevitably, the stock “crashes”.
Making Undervalued Stocks Work for You
A value-based investment strategy finds those stocks that are undervalued and purchases them when their prices are lower than the company’s intrinsic value. Investors who follow a value investing strategy believe that the market will likely improve and/or the stock’s value will rise as it overcomes whatever challenges the business is facing. Another element of this strategy is an avoidance of those stocks that might be overvalued by the market to protect the portfolio from the possible downside risk of the overvalued holdings.
Finding Undervalued Stocks
Finding undervalued stocks is likely going to take time as you sift through different companies, their financial reports, and official websites for the information you need to make a qualified decision. Compiling data so you can easily track the results, and narrow down which stocks to invest in, is necessary in order to stay organized.
Is it time for you to look at undervalued stocks to add to your portfolio? Give the team at Granite Investment Advisors a call at 603-226-6600 to talk about how your current portfolio can take advantage of a value investment strategy and to assess your overall risk tolerance.
Past performance is no guarantee of future results. Returns are presented net of management fees. There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors’ recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.