Finding undervalued stocks is the next in a series of articles on the basics of evaluating company shares.
Previous articles in the series included:
Don't let the title confuse you. In this article about finding undervalued stocks, I just want to you to fully understand what parameters are important.
If you have read any of the articles on Stock Market Legends, you will have noticed that all of these stock trading studs, without exception, attributed their success to keeping to a set of rules.
Even I concocted my own set of rules, many moons ago, and have modified them a lot since. I will reveal them at some point in this series of articles.
But right now, I want to insert a few words about market capitalisation.
You've no doubt heard about "Blue Chip" companies? They are the ones that can't go bust. Right?
Don't delude yourself. Think Rolls Royce and Maxwell.
If I had a set of rules, which I do have, but I'm not going to reel them off just yet - but perhaps only trading in "Blue Chips" would be my first rule.
But I prefer to call the companies that I trade in as "high cap" shares. A share's Market Capitalisation is the share price multiplied by the number of shares in issue. You can find a compnay's market cap in most daily newspapers and from all financial information sources.
Take for example the shares of Glaxo Smith Kline (GSK) , as of 18th. November 2020 the share price is hovering around the 1372p mark, showing a Market Capitalisation of around £70 Billion.
Without having to look at the company's annual statement, my trusty calculator reckons that means there must be over 50 Billion shares outstanding.
Quite frankly, I'm not too interested in how many shares there are, what I am interested in is the market cap. As a general rule, I like to invest in companies that have a market cap greater than £1 Billion.
For an exceptionally good company I may invest in a company with a market cap of £500m but no less than half a £ Billion.
And even at half a Billion pounds, the marketability of the shares can be "sketchy." For example, a company valued at, say, £400m might have a daily trading volume of only 100,000 shares. Compare that to GSK with an average daily trading volume of 8 million shares.
So what? You might say. Well, it can be big deal. I only want to trade in shares that are highly marketable. If I were to get a quote from my Pension Provider's Trading Platform for GSK the quote would probably be 1372.2p/1372.4p - meaning that they would be 1372.4p to buy and 1372.2p to sell. A difference in the buying and selling price (the "spread") of 0.2p
If I wanted a quote for my £400m market cap company I would probably get something like: 447p/463p - a whopping spread of 16p which would mean that you would need a substantial change in the price to make any profit.
Stay well away from low-cap shares.
So if I was making rules, this could be one of them: only trade in high cap shares, preferably those with a market cap. greater than £1 Billion.
It's easy to get carried away. The reason why markets fluctuate the way they do is because people get greedy. They think the party is going to go on forever. This is when the smart investors dump their stock.
Similarly, people get fearful. The markets goes into decline. They think it's going to crash. This is when the smart investors fill their boots.
In my lifetime it's happened many times. And many time before that - most notably in 1929 and the Second World War. I remember well the long Bear Market of the early 70s, the recession of the 1980/81, the 1987 crash, the dot com boom/bust, the finanical crisis of 2008/9, and now the Covid-19 palava.
I made money in just about all of those post-war scenarios. Some times, a lot of money. But why? I'm nothing special, I'm just an average guy who likes to be down the local on a Friday night.
In fact, I made money twice on each occasion. Once when the markets were over-sold and again when they became over-bought.
Just take a look at the diagram on the left.
It's easy to spot the 1929 crash. But what about the Second World War, the Bear Market of 1970-74, the 1980/81 recession, the 1987 crash, the dot-com boom and bust, the financial crisis of 2008/9?
With the exception of 1929, all the other market reactions were just blips.
Blips along the way in the market's continuous drive upwards. Imagine drawing a line, roughly marking that upward trend. Do it on a smaller time-frame. Then look to see - is the price above or below that line?
And by how much?
Use your common sense to decide if markets are too far one way (over-bought) or the other way (over-sold). What is the volume of shares being traded?
Decide to get in, or get out. Of course, you will look at a lot of other data before you decide, but you know that markets gets over-heated and over-sold. You will never get out at the top, and you will never get in at the bottom - so don't even try.
Take today's markets for example. The pandemic arrived in February/March this year (2020). And markets moved down substantially. I can't believe that some financial "advisors" were telling their clients to get out. [The time to get out, would have been before the fall, not after it].
Bad advice or what?
Similarly, when the markets get over-heated, financial advisors are not telling their clients to get out. They obviously think they can squeeze a bit more out of an over-heated market.
That's not professional advice at all. Maybe they just like to generate commissions for themselves.
Right now, the markets have rallied. Trump has lost his job. Vaccines to "cure" the virus are close to coming to market. Wall Street is hitting new highs. Volume is above average. Countries are piling up massive debt, unemployment is rising - fast.
Any ideas on what the markets might do?
No, neither have I.
Lots of scenarios raise their ugly head.:
Only time will tell - but I've been around long enough to be very suspicious of this market.
Let's not forget, lives have been ruined. Businesses have gone to the wall - never to return. Company profits are down. There is mass un-employment.
Markets can recover, we've seen that over the past 100 years. Markets will recover. That upward trend of the Dow Jones, and other world indices, will continue. Of that, we are fairly sure.
But I'm not a financial advisor. I'm just an ordinary investor like you. But we are all entitled to our opinion.
Finally, always ask yourself the question: What would Warren do?
Warren Buffett, and his mentor Benjamin Graham, reckoned that they had no time for Technical Analysis. Yet they both have gone on record as saying that they first choose a share, and then they wait patiently until that share is at "the right price" before buying.
My point is: How would they know what the "right price" is if they don't have some kind of a visual representation? They may have a chart going on inside their head.
Back to the original question. Warren would be continuously monitoring the situation. He already knows which shares to buy - he's done his homework a long time ago - he now just waits for the opportune moment to buy them.
But his big secret is: How does he pick his shares?
Another factor to consider when finding undervalued stocks is the Yield, which is based on the Dividend and therefore sometimes referred to as the Dividend Yield.
When we buy an investment, and in our case that investment would be a company share, we expect some kind of benefit. With company shares we mean to do a fair amount of research in order to buy the right share at the right price but we expect a reward, in the form of profits, by doing so.
What we are trying to do is: first identify shares that are undervalued and secondly buy those shares at the right price.
What we would then expect is for those shares, over time to increase in value. That's our profit and over a year would be measured by a percentage rate of return.
Warren Buffett has achieved an average annualised rate of return of over 20%. Quite some feat when you consider that markets have only averaged around sigle digit growth over the same period.
But there is a second way that investors can benefit from buying company shares.
A lot of companies pay what is known as a Dividend. In your daily newspaper this will be expressed as a percentage and is known as the Dividend Yield. Of those companies that pay a dividend, the Yield is calculated by expressing the Dividend as a percentage of the current share price.
What actually is a Dividend?
You own shares in a company which means that you own a (very small) part of that company. And, as such, you are entitled to a share of the profits that the company makes. Not all companies pay a dividend, but for those that do, it is one way of sharing the profits of the company.
Some companies pay a "special" dividend in addition to their normal, if the company has done exceptionally well in that year.
Warren Buffet's company - Berkshire Hathaway - has never, ever paid a dividend. Normal or special. He likes to plough all the profits back into the company. The most recent share price of Berkshire Hathaway was: $352,500
So, what's a high Dividend and what's a low Dividend?
This will fluctuate, but let's say the average market Yield is around 4%. Is that good, bad or we just don't know? And each sector will have its own average Yield. Individual share yields should be compared to these averages.
Let's take an actual example. At the time of writing this article GSK shares were trading at 1,374.8p and the Yield was quoted as being 5.42% (above the market average).
A Yield of 5.42% was based on the Dividend paid out by GSK but based on last year's accounts and implies the a payout of: (5.42 x 1374.8) / 100 = 74.5p per share.
If GSK's share price were to rise, let's say to 1500p then the Yield would be quoted as:
(74.5 / 1500 ) x 100 = 4.96%
But if GSK's share price were to fall, to say, 1000p then the Yield would be quoted as:
(74.5 / 1000) x 100 = 7.45%
Does this imply then that a high Yield is indicative of a cheap share and that a low yield is indicative of an expensive share?
The reality is that if a company's Yield is too high - let's say above 8% - it looks attractive from a income point of view, but it could be dangerous. It could be a signal that the company in question is unable to pay such a high dividend. Not always the case, but it's a red flag.
Conversely, in October 1987 the average market Yield was 2.89% and then look what happenend.
The above is very general but nevertheless, one to be wary of. Clearly, if you see Yields of 10% or greater you would be right to be suspicious - it may not mean cheap.
Warren Buffett doesn't have this problem, he dislikes companies that pay a Dividend. He prefers for the company to plow all their profits back into the company so it can grow even more. For a well-managed company, the profit will be seen in the increase in the company share price. (Best example being Berkshire Hathaway).
Personally, I look at Dividend Yields, but I wouldn't want to base my investment decisions on them. It appears that too high a Yield can be dangerous and too low a Yield (for the market average) could also mean trouble.
I'll use Dividend Yields as just one more indicator, and not a very decisive one at that.
Warren Buffett crunches numbers all day and every day. It's what he's done since he was a kid. It's more than likely that he knows infinitely more than any other investor - ever.
The rest of us can only hope to keep up as best we can.
Warren Buffett in his quest for finding undervalued stocks likes to look to the future.
When you pore over your daily newspaper and look for your favourite shares, there is a column marked: P/E.
The Price Earnings Ratio, covered elsewhere on this website, is simply the current share price divided by the company earnings.
For example: way back in September of this year (2020) GSK were trading at just under the 1500p mark with Earnings Per Share of 126.30p Their P/E ratio was therefore: 1500 / 126.3 = 11.87 Low and below the market average of 12 (just).
Towards the end of October, GSK shares had fallen to 1284p and the P/E became 10.16
As recent as 18th. November, GSK shares had recovered to 1374.8p, resulting in the P/E ratio rising to 10.88
However, the Earnings Per Share used to calculate those P/Es was 126.3p. The same value in each case.
Those Earnings are often referred to "historic" because they are the company earnings from the latest set of accounts. The P/E ratios calculated using these "historic" earnings are useful but no guide as to where the shares might go from here.
P/Es calculated in this way are flawed. Past earnings are no guarantee of future earnings, even if they have been rising for 10 years or more consecutively. The following year a company may make a loss, or at best, a decrease in earnings.
Covid-19 could well have put a lot of companies that were making good earnings, year in, year out, into losses. I believe that will indeed be the case, and is yet another reason for caution in these markets.
Is there a solution to being able to analyse P/E ratios?
Enter Warren Buffett.
He likes to look at "future" earnings, and the bulk of his research on a company is trying to estimate what the future earnings of a company will be. A lot of city analysts are doing the same thing.
But Warren, being Warren, goes 10 steps further. He wants to estimate the future earnings of a company 10 years ahead.
Warren Buffett looks for consistency - a steady rise in earnings over the years. The companies he likes to invest in are protected by what he calls an Economic Moat. They must have what he has dubbed a "Durable Competitive Advantage." With the emphasis on the word: durable.
There are only certain companies that have this Durable Cometitive Advantage. Companies that do not possess it, he is not interested in - he calls them Commodity Type Businesses.
The companies Warren likes to invest in are called: consumer monopoly companies.
The key to investing like Warren is in the estimation of their future earnings.
Going one step further with company earnings. Some boffin came up with yet another ratio called the PEG Factor.
The PEG Factor was made popular by Jim Slater in his book: The Zulu Principle. But it was nothing new, The Wall Street Journal wrote about it many years before.
Unlike the P/E ratio (historic), the PEG Factor is not readily published but it is a well-used ratio and excellent for finding undervalued stocks and overvalued stocks.
A PEG of 1 is neutral. The market average is around 1.2 but can fluctuate. If a company has a PEG factor below the market average, it is thought to be better value and thus more likely to rise.
If a company's PEG Factor is above the market average it is judged to be overvalued and less likely to rise but more likely to fall.
As an example: if a stock has projected earnings of 20% per annum and its P/E was 10 (or lower) then its PEG Factor would be 0.5 (or lower).
The P/E ratio is available in all daily newspapers, and the expected growth rate of earnings may be found in your Trading Platform dashboard, if not, ask your provider. [But even that will only be for one year - not ten like Warren likes to go with].
The PEG Facor is then obtained by dividing the P/E ratio by the expected growth rate.
As mentioned earlier, a PEG of less than one (or the market average) may indicate that a particular share, or sector, is undervalued. A PEG of greater than one (or the market average) suggests waiting until the PEG drops below one.
... as always, the PEG Factor is but one ratio. Never use a single ratio in isolation. It is too dangerous. Always look at the complete picture you have painstakingly built up.
It's got to be obvious to anyone that finding undervalued stocks is not easy. If it were ...
However, it can be done. Even by us relatively un-informed amateurs. There's just the small matter of doing a little bit of research.
In this article, and previous ones, it has been the intention to drip-feed the type of information required in order to make an informed decision on finding undervalued stocks.
This article has, hopefully, consolidated your understanding of some basic investing parameters. Namely:
In the next article, finding undervalued stock, I will cover:
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/
Chris and Clem Meet Up - hopefully, the last time before lockdown easing
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