Finding undervalued stock is the next in a series of articles on the basics of evaluating company shares.
Previous articles in the series included:
In this article I will cover:
1. Director Dealings
2. Supply and Demand
4. The Trend is Your Friend
5. Annual Events That Influence Markets
This article attempts to cover other areas that private investors need be aware of. I call them - more pieces of the jigsaw.
The ultimate aim, of course, is for you to understand the basics before moving on to methods used by our hero, Warren Buffett.
Finding Undervalued Stock takes time - sometimes a lot of time.
It also takes effort. A lot of research - most of the time - fruitless.
And it requires tons and tons of patience.
But look what it has done for Warren Buffett. We can't possibly hope to emulate what he's done. He's a financial genius. He has been from an early age. And he was mentored by the best of his era. And then rubbed shoulders with the best.
And now he is partnered with the best.
Probably the best way to start finding undervlued stock is with a list. Either in a journal or on an Excel Spreadseet. If you are dapper with spreadsheets (I'm not very) then that's the way for you. Knowing your macros and little shortcuts will itself save you hours and hours.
If you are not good with spreadsheets - get yourself a wee bit of education on the topic.
Once set up - start with your list in descending order of market capitaliation.
Last time I looked - Unilever was out in front with a market cap of £120 Billion, followed by Astra Zeneca and Royal Dutch Shell valued at around £102 Billion each, BHP Group on £88 Billion, HSBC on £82 Billion and Glaxo Smith Kline (GSK) "trailing" on £74 Billion
Make a list of all companies with market caps in descending order all the way down to around the £500 million mark. A lot of companies, but many of them will be deleted, as they will be either the wrong type of company (i.e. commodity type businesses) or just not attractive in other ways.
The columns in this list should contain, but not be limited to, the following:
You could also add columns for Price but this would of course change daily.
Examining the resultant spreadsheet would give you a 'broad brush' idea of what to look for, you would then need to do some deeper research into how the company has fared financially over the past 5 or even 10 years.
And, if you want to emulate Warren, what are the company's future earnings prospects?
Above is the "broad brush" idea of what to look for. The above caption is just an example - it is the top 13 companies in the FTSE-100 Index by market capitalisation.
As you can see, I have tried to identify the Commodity type businesses and the Consumer Monopoly type businesses.
In true Buffett style - I'm not interested in the Commodity type businesses. And, at this stage at least, I'm only interested in those companies with a P/E ration less than the market aaveraage - which for now, I'll take as being around 12 or 13.
As you can see, I have highlighted those companies that make that criteria.
Stripping out the Commodity type businesses, that leaves just GSK and BATS. But of course, there are many more companies in the list - shown here are only the top 13 to give you an idea.
What I do next is dig deeper.
I want to see all the relevant figures for the previous five years - at least. But preferably ten years.
Of the two shares singled out above, i.e. GSK and BATS I know for a fact that they are Consumer Monopoly type businesses and therefore, providing the figures stack up, I would be very interested in buying them - if the price was right.
That's a lot of "ifs"
I also know that Imperial Brands is very similar to BATS, lthough they are not shown in the table above - they too have a low P/E ratio - under 10. Maybe they are a bargain. Your in-depth research will prove this.
In the next arrticle in this series: 'The Price is Right' I will disclose my deeper research for at least three companies. So look out for that.
Another aspect of finding undervalued stock is to monitor what the directors are doing in respect of their shareholdings.
Are they buying? And if so - how many? Why are they buying?
Are they selling? And if so - how many? Why are they selling?
Most director dealings are done for personal reasons. Usually regular transactions.
Director sales do not concern me as much as director buys. If I were to notice some rather large transactions, and more than one director, I might sit up and take notice.
Having said that, it is illegal for directors to buy and sell their company shares before it is general knowledge. Similarly, directors are forbidden from trading in their company shares directly prior to any announcements.
I have never once spotted a director profiting in this way. But that will not stop me from looking to see who is trading - the information can be found in most good daily newspapers and the week-end Financial Times - Director's Dealings
Only this week - the Chairman of Carnival Cruise Lines sold £77m worth of shares - ask yourself why. The shares have recovered somewhat but are still a far cry from their year high.
The Russian billionaire shareholder in 'TUI Travel' has hinted that he wants to increase his stake in the company from 25% to 36% - he may have to settle for 29.9%. But what are his intentions?
And Tim Martin of Witherspoon's fame sold £5m worth of shares. He also sold £5m a few months ago. Another case of the shares recovering from a low of 559p to around 1250p
They had been as high as 1734p What does he know that we don't?
Food for thought!
There are two principles in the markets that can change the direction of the market:
1. The majority of "punters" a.k.a. "The Herd" buy like there is no tomorrow in a rising market. Everybody and his brother wants to pile in on the slightest bit of good news. They don't want to miss out on a sure thing.
2. These very same "punters" panic like crazy when the markets make substantial falls. They think the markets are going to crash. They are easily shaken out of their trades on any bad news.
You must ask yourself the question about 1. above: what stops the market from going to the moon?
And about 2. above: what stops the market from crashing any further?
A partial answer to both points is that markets consist of two kind of traders: amateurs and professionals.
Yes, even seasoned veterans of the markets can be classified as amatuers. Why? Because they have never taken the trouble to find out how the markets really work. Always trading on tips and hunches. If these traders are honest, they will admit to losing trades more times than they experience winning ones
So what makes the difference?
Professional traders know what is going on. First of all, he is trained to not be driven off course by good news, bad news, tips, advice from brokers - in short - he is disciplined.
And he knows what to look for.
When markets are hitting dizzy heights, he can see that the markets are getting tired. And so too can all of his professional trader friends. Demand is out-stripping supply. As the amateurs are gobbling up shares - the professionals are selling theirs to them.
It's called a transference of ownership from weak holders to strong holders.
A point is reached when the demand from the amateurs can no longer be satisfied from the supply from the professionals - they have unloaded all the available supply - there is none left. There is only one direction for the shares to go - down!
This process is called "Distribution."
Similalrly, when the amateurs are panicking after substantial falls and all they want to do is get out before they "lose" more money - the professionals can see this - and begin to buy. It's not long before all the supply (the shares the amateurs are trying to dump) is absorbed by the professional demand.
A point is reached (it could take weeks or even months) when all the supply has been absorbed by the professionals. Then there is only one direction for the shares - up!
This process is called "Accumulation."
As an investor - as opposed to being a speculator - this buying and selling should not concern you too much as when you buy, you will be buying for the long term. However, in a severe Bear Market, it could pay you to sell and then get back in at a cheaper price.
All so easy in hindsight.
Our friend, Warren Buffett, does not sell. He buys at the "right price" and hangs on in there - come what may. Has he been proved right?
Would you say that the picture over to the left is worth a thousand words?
Perhaps it is worrth a million words!
Or should I say a million pounds!
This picture, or chart as it is commonly referred to in marketing circles, really does tell a story.
The problem being though - it is all retrospective. That's what the Dow has done over the last 100 years or so, but surely, it is no guarantee that it will continue to be so. That is, in an upward trend.
No - there are no guarantees in life. And this is no exception. But the probability is that it WILL continue its upward trend.
We like charting.
Warren Buffett hates charting.
We are a little at odds with the fact that Warren Buffett does not entertain charting. He refers to buying at the right price often enough. How does he know what the right price is?
Being simplistic - we would look at our charts.
Want to know more about charting - then hop over to: Market Charting
Has it ever crossed your mind why the FTSE 100 Index has risen just about all the time ince it was introduced in 1984 (and before that, the FT30)?
As you know by now, the FTSE 100 Index is comprised of the top 100 companies in the UK - by market capitalisation. But hey, the Dow Jones Industrial Average in the US comprises of only 30 companies - and the rise, and rise, of that market shows no end.
So why is it that world Indices continue on this upward path? Will they always do so?
There are a lot of contributory factors at play - things like inflation, the fact that the bigger companies getting bigger and bigger, but the Stock Exchange want the index to maintain its momentum and "cheat" a little.
Every so often, around every three months, they will look at the poorest performing shares that comprise the index and replace them with more up-and-coming shares from the FTSE 250 Index. The poorer performing shares will then be relegated to the FTSE 250 - and vice versa.
This can't help but assist in the Index continuing its rise and rise.
There is a very quotable phrase in the corridors of trading - the Trend is Your Friend.
And long-term, that trend is upward.
Warren Buffett reckons he doesn't look at charts. He's got to be modest with the truth there. But he, above everyone else, knows that the long-term trend of the markets will be upwards.
Short-term, there will also be trends. It's all a matter of what type of investor you want to be. There will always be Bull phases and Bear phases. But you gotta be real careful. These phases are all too easy to spot in retrospect, but not so easy to identify in real time.
That's why Warren likes to call the majority of his investments - forever stocks. He backs the long-term trend of the market. But ... the way he is so different to everyone else, lies in his choice of company to invest in.
He knows, with almost 100% certainty that when he identifies the right company, he only then has to identify the right time for him to buy.
The he just lets the trend be his friend.
This section is just a bit of fun. Don't take it too seriously.
Other, so-called traders, will buy and sell shares on any whim and fancy.
These people are not investors, they are speculators. Sure, they call themselves traders but speculating is what they do. Sometimes they win and sometimes they lose.
Their philosophy is to win more times than they lose. That kind of "trading" has no place on this website.
However, there are certain events that these speculators like to trade in and although we do not advocate short-term trading strategies, these "special situations" could sway you one way or another, if you are thinking of entering the market at that time.
So what are these wacky things that might influence the markets - albeit short term?
1. Seasonal Events
One really wacky strategy has been to buy the five defensive sectors (Beverages, Pharmaceuticals, Tobacco, Personal Care and Utilities) at the beginning of April and get out of five cyclical sectors (Construction, General Industrials, Software, Telecoms, Electronics and Electrical Equipment).
And look to make a profit by September.
2. The U.S. Presidential Election
Traders reckon that this strategy has NEVER failed. Hmmm!
The strategy is to buy the Dow Jones Industrial Average on the 1st. January in the third year of a presidential cycle. Keep the position open until the end of that year for an average gain of 17.9%. Alternatively, buy the FTSE All Share Index for the same period.
An even better trade (so "they" say), is to buy the S&P 500 Index on 1st. October in the second year of the presidential cycle and hold until the 31st. December of the next election year.
Scoff if you like. But this strategy has performed really well, producing an average profit of 40% in each of the 27 month periods for the last few decades.
3. Santa Claus Rally
Most people are tempted to buy the market at the end of November, but past history as proved that by buying the FTSE All Share Index on 11th. December and selling by 5th. January, is a better bet.
But the word "bet" is the operative word. It's risky.
4. Religious Holidays
There are others, but the pick of the bunch is to buy the S&P 500 Index two days before St. Patrick's Day (that is - buy on the15th. March) and then sell the day after the holiday (18th. March).
Depending on when St.Patrick's Day falls, will determine the exact days to get in and out.
None of this section is to be taken seriously - it's just a bit of fun. Although, there really are punters out there that "trade" this way. I don't think my nerves could stand it to be honest.
I've included them here as a little bit of fun. Helping you to forget the lousy year that it's been (because of Covid) and it is the season - the season to have a bit of fun.
This article has meant to demonstrate that there are, even if it is only for the short term, other means of finding undervalued stock.
As stated in the text, we like charting. We believe that even a simple line chart can be informative. In fact, we are making the next article in this series all about Warren Buffett's statement of: 'The Price is Right' - so look out for that in the next week or so.
With most of the basics covered, the time will then be ripe to concentrate more on the thinking of Warren Buffett. Seriously, you need to watch this space. You will not get any of this information from your financial advisor or financial press.
Keep coming back to this website - more and more is being added. And ...
... it's free!
Want even more information? Then hop over to: https://markets.ft.com/data/