Sunday Edition: Identifying Undervalued Stocks

September 11, 2016

Sunday Edition: Identifying Undervalued Stocks

The $64 million dollar question asked by every investor is, “when is the right time to make an investment and actually buy shares in the said company?”

One of the big advantages of value investing is the fact that the question of when you should invest, while never being irrelevant, is only a secondary concern. 

The focus is on first determining whether a stock is available at a discount compared to how much the business is worth; if a discount exists, the value investor has an immediate advantage over the rest of the market (which has yet to recognize the stock should be priced higher than it is) and should take a position as quickly as possible.

I agree completely with Benjamin Graham, however, having been a long-time student of “technical analysis” myself, I do believe that analyzing historical price trends can help investors further refine their entry into a given investment.  

This is true whether one is looking to purchase shares outright or to first sell a put option to generate income with the potential of being assigned shares.

In today’s reprint of of Rebel Income (annual subscription $1,164), Thomas explains a perfect marriage of identifying fundamentally undervalued companies with historical price trends to optimize the timing of your entry.

Here’s Thomas:

Week 7: Identifying Undervalued Stocks

The Rebel Income system is designed to work with fundamentally solid, dividend-paying stocks currently trading at a price that represents a terrific value. While fundamental analysis by itself is a useful way to analyze the company behind a stock to determine how effective they are at running their business, turning a profit, and finding ways to grow and expand, one of the critical mistakes that a lot of investors make is to assume that because a stock’s fundamentals are good, it’s a great investment right now. The problem is that while fundamental analysis is a good way to determine if a company might be a good place to put your money because of its underlying business strength, it really can’t answer the most important, $64 million question: when the time is right to make that investment.

The $64 Million Question

The question of when the time is right to put your money to work for you can be answered in a lot of different ways. Short-term traders and speculators like to use stock charting methods to identify points in time where a stock’s price has previously swung from low to high and back again, and then place their trades based on their analysis of those swings relative to the stock’s current price. A stock that appears to be poised to swing from a low point to a high point, for example, could provide a good opportunity to buy the stock low, then make a quick profit as it swings higher. This is an approach I like to call directional trading, because it follows the basic precept that everybody automatically thinks about when they think about the stock market: buy low and sell high.

Directional trading sounds good and logical, but the fact is that it is also very difficult to do successfully. Trying to pick the top and bottom of any move before it has actually happened, which is intrinsic to a directional method, is really nothing more than guesswork when all is said and done. It’s one thing to look a stock chart and recognize historical reversals from low to high or high to low; but quite another to say, for example that because a stock started to go up today after several days of downward movement, it is going to keep going up. There is no crystal ball that is going to provide a consistently accurate prediction that a stock will keep going the way you think it will.

More than 20 years ago, Jack D. Schwager published a book called The New Market Wizards. In it, Mr. Schwager detailed interviews he had conducted with some of the best and brightest traders in the market. He asked them about their trading methods, how they had developed them, and what their results were like. One of the most revealing elements of each story is that the traders whose systems were based on the simple buy high first, then sell high concept consistently admitted they were right about the direction of their trade only a small fraction of the time; ranges between 30 and 40% were the norm, which meant that these enormously successful traders, many of whom manage large institutional funds and assets, place losing trades far more often than they have winning, profitable ones. The simple fact that directional traders—no matter how skilled, knowledgeable, or experienced—have to accept a higher number of losing trades than winning ones is the reason most everyday investors fail.

It is true that it is possible to make money with directional trading; however, it requires a mindset that can not only accept the reality of losing far more than you win, but also the reality that losing streaks are normal. Imagine placing your first stock trade and watching it lose money. That’s already an emotional letdown; now assume you make your next investment and it loses money, too. Now imagine that you place half a dozen trades and every single one loses money. Would you be willing to keep trying, or would you be ready to throw in the towel and start looking for something else to do with your money? If your answer is to throw in the towel, don’t be discouraged – that just means you are normal. It is a rare person that can stick with a trading system that will see several losing trades in a row on the assumption that when they do finally get a few winners, they will be big enough to justify the entire effort.

The $64 Million Answer

I think that there is a better way—a simpler, more efficient, and far less stressful way—to answer the when question about an investment. It doesn’t turn a blind eye to a stock’s current direction, but instead is designed to identify stocks that have a built-in reason to go up. It’s called value investing.

If you’re a bargain shopper (who doesn’t like to find a good bargain? Nobody!), you’re already naturally wired to be a value-oriented investor. In a very similar way that you might dig through the clearance rack at a department store to find a great set of clothes at a terrifically discounted price, value investing combs through the thousands of stocks on U.S. exchanges to find those great companies that, right now, are trading at much lower prices than they should be. This is a method that was pioneered by an investor named Benjamin Graham. Graham was a successful financial researcher before the Crash of 1929, and like most investors at the time, he lost almost all of his personal fortune. Graham used that experience to refine his approach to the market, and in 1934 he published his first book, Security Analysis, a book that has never gone out of print and today is still considered an investment classic. That book was followed fifteen years later by The Intelligent Investor, a book that set forth Graham’s philosophy about quantifying how much a company is actually worth at any given time. Like Security Analysis, The Intelligent Investor has never gone out of print and is considered a must-read for any serious fundamental investor.

Graham’s approach to identifying a company’s actual value based on its book of business, and then comparing it to the stock’s current trading price not only helped him rebuild his personal fortune; it was also used as the central tool for an investment partnership Graham started in 1926 with Jerome Newman that survived the crash and averaged a 17% annual return until his retirement in 1956.  As an instructor on finance at Columbia University, Mr. Graham mentored some of the most successful investors of the modern era including Warren Buffett, who has publicly credited him as being the second most influential person in his life after his own father.

One of the biggest advantages the value investing approach favored by Benjamin Graham and his many disciples has is the fact that the question of when you should invest, while never being irrelevant, is only a secondary concern. The focus is on first determining whether a stock is available at a discount compared to how much the business is worth; if a discount exists, the value investor has an immediate advantage over the rest of the market (which has yet to recognize the stock should be priced higher than it is) and should take a position as quickly as possible.

It’s true that finding even a deeply discounted stock is no guarantee the stock will increase in price in the short term. That’s why value-oriented investors accept the reality that the stocks they do buy will in many cases require a year or more to yield an attractive rate of return. Value investing isn’t about timing the ebbs and flows of the broad market; it’s really just about determining if the stock you’re looking at should be worth more than it is right now. If it is, there is probably a good opportunity to be had for the patient investor. The real question that we need to answer, then is: how do we figure out how much a stock should be worth compared to its current price? There are a few simple metrics the Rebel Income system uses:

  • Book Value
  • Price/Earnings Ratio
  • Current Price versus Historical Levels

Book Value

The simplest definition of Book Value as it relates to individual stocks is assets minus liabilities. It is expressed as a per share value, just like a stock price. For a value-oriented investor, Book Value provides an effective means to determine how undervalued a stock might be.

In the letters he is famous for including with the annual reports for Berkshire Hathaway, Warren Buffett has referred to Book Value as the amount shareholders would receive today if a company closed its doors, paid all of its remaining expenses and liabilities, and its assets were liquidated. I like to think of Book Value as an expression of a stock’s intrinsic value – the portion of a stock’s price that can be tied to its business and management strength.

Fundamental and value-oriented analysts use a stock’s Price/Book ratio as a quick-glance view of where a stock’s current price is in relation to its Book Value. A ratio of 1 implies an equal relationship between the two, while a number below 1 means the stock is trading below its Book Value and a number above 1 means the stock is trading above its Book Value. An ideal stock for the Rebel Income investing system will be near to its Book Value, or at least significantly below its historical Price/Book ratio average, with solid fundamentals across the board based on the data listed in the previous section.

Price/Earnings (P/E) Ratio

Price/Earnings ratios, or P/E ratios have long been one of the most commonly used and accepted quick-glance measurements of whether a stock’s current price is undervalued or overvalued. Depending on the service you get this number from, it could be based on the last twelve months’ worth of information (which is commonly called trailing twelve months, or TTM) or on the most recently reported quarter (MRQ). The calculation is simple: divide the stock’s current price by its earnings per share (EPS). The result is a multiple of the stock’s earnings per share. For example, if a stock’s EPS for the last twelve months is $3.00 per share and their current price is $30 per share, the P/E ratio is 10, meaning that the stock is trading 10 times higher than its earnings per share.

In a similar fashion as with its Book Value, it is entirely normal for a stock’s trading price to be several multiples higher than its earnings per share. One of the big differences is that since earnings per share are usually a smaller number than the stock’s Book Value, P/E ratios will almost always be higher than Price/Book ratios. Analysts also like to compare this value with a stock’s industry group, since some industry groups are accepted by investors at large as trading at higher multiples than others. For example, finding a stock with a P/E ratio of 12, in an industry group with an average P/E ratio of 20, may be a good indication you’ve found an undervalued stock with a great investment opportunity.

You can think of the P/E ratio as being an expression of how much investors are willing to pay for a dollar of that stock’s earnings. This is a useful approach, since it gives you a way to use historical P/E information. If a stock’s historical average for the last few years shows the stock usually trades around 17 times earnings, but it is currently below that number, the stock could be undervalued, since investors are usually willing to pay more. You might have an opportunity to get in before everybody else starts to notice the discrepancy and pushes the stock back up to its historical norms.

One of the limitations of P/E ratios—as with a stock’s Price/Book ratio—is that a low P/E ratio gives no additional insight; it doesn’t, for example, provide any information about why the stock’s P/E ratio is low right now. It could be a function of market trends, or possibly of fundamental deterioration in other areas of the company’s business. Sometimes stocks get pushed to historical lows because the company is facing new, serious challenges that threaten its ability to stay in business. This is why I never use a stock’s P/E ratio alone as a barometer of a company’s value proposition. I’ve built the Rebel Income system to incorporate P/E ratios only as a supplement to a stock’s overall fundamental profile and Price/Book ratio. If the fundamentals are solid, the Price/Book ratio is attractive, and its P/E ratio is lower than normal, then the stock is pretty close to the “sweet spot” I’m trying to hit.

Current Price versus Historical Levels

Investors and analysts who rely on fundamental and value-focused analysis often exclude any evaluation of a stock’s current price activity from their system. The logic behind doing so suggests that if a stock’s current price represents a bargain relative to its intrinsic value, where the stock is trading relative to historical patterns is irrelevant. The bargain status implies the stock should be worth more than it currently is, and that should be the overriding concern for the purposes of making an investment decision. The longer I work with the market, the more I disagree with this logic;  that’s why I’ve made analysis of a stock’s current price relative to previous price activity the third part of my value-oriented analysis.

In ideal terms, investing should always be done objectively, based on solid, established and proven principles, and executed in the same fashion on each and every trade. The weak link for every investor, no matter how experienced or knowledgeable we may be, is the natural tendency we all have to impose our own emotions, and therefore our imperfect subjectivity, on those investments. We aren’t computers, and the simple fact is that any time we’re about to put real money at risk, our emotions come into play. Ignoring a stock’s historical price activity in your analysis actually exposes you to even more emotion-based risk, because it encourages you to dismiss any consideration of whether the stock may be more likely to go up or down—in possibly dramatic fashion—in the near term.

Instead of relying exclusively on measurable data points like Book Value and P/E ratios, I think it’s smarter to use a stock’s historical price action; in part, I’ve found it helps me to minimize and manage the emotional expectations that naturally emerge with each investment I make. In this sense, I’ve incorporated many of the same analytical principles that are the cornerstones of shorter-term trading methods like swing and trend trading. While I don’t attempt to “time” my entries or exits based on this information, being able to recognize historical price swings and trend reversals, and identify current trends across multiple time periods provides a better overall understanding and perspective of a stock’s current market risk or opportunity.

Under ideal circumstances, an undervalued stock is at, near, or below its Book Value, with a P/E ratio below the industry average, and trading at or near historical lows. When all three elements are in place, it becomes much easier to commit hard-earned investing capital to a stock. It also makes managing the emotion of the investment after it’s made less stressful. None of these three elements guarantee the stock will go up in the short-term, or even within a few months; but they are a strong indication that the company’s intrinsic value is higher than its current trading price. The investors that can recognize this reality before the rest of the market does are the ones that, like Benjamin Graham, Warren Buffett, and many of the most successful investors in the history of the financial markets, will best be able to weather economic storms and the ebbs and flows of market cycles and come out ahead of the game.

I believe the unique combination of Fundamental and Technical Analysis that Thomas uses is a big reason for his spectacular returns over the last two years. He has closed 104 of 107 winning trades turning every $10,000 invested into $18,075 and substantially outperforming the S&P 500.

The Rebel Income system is designed first around selling a put option on a deeply undervalued company to generate income, knowing in some instances we will be assigned shares and can then collect dividends and sell covered calls to generate additional income.

To get a first-hand look at how Thomas creates such a high percentage of winning trades and annual returns that match those of investing greats such as Warren Buffett, Carl Ichan, and David Tepper, we’ve arranged for you to follow his picks for the next 30 days for only $9, with no obligation to continue. You’ll also receive two incredible bonus items free. 

Click here to get started on your $9 30-day trial.


Shane Rawlings
Co-Founder, Investiv