"Undervalued Stock Is The 'Holy Grail' of
All Value Investors - Benjamin Graham Knew It,
Charlie Munger And Warren Buffett Know It,
They Have Built Their Fortunes On It"

Introduction

This article is a direct follow-on from a previous article titled: Undervalued Stocks.

In that previous article we gave a (very) brief introduction to the subject of finding undervalued stock.  This article picks up where that previous one finished.

This website has a main page devoted to Fundamental Analysis, but this "mini series" of articles intends to look at the topic from a different angle. 

You have have appreciated by now that the "Holy Grail" of investing is finding undervalued stock.

It's what Warren Buffett has always done, it's what us mere mortals should try and do.

The intention of this mini series of articles is to introduce you to Warren's world of finding these nuggets of gold.  Mr. Buffett has spent his entire lifetime finding these gems and look what his reward is - $90 Billion and still counting!

Wow! a fraction of a fraction of that would be enough for us.  What about you?

But how does he do it?  Ah, now that's the million dollar question (or should we say: the $90 Billion dollar question?)

Before we even try to explain his research techniques, you need to know a lot more about Fundamental Analysis. So, without further ado, let's dive in.

"More About Fundamental Analysis and The Path To Finding An Undervalued Stock"

Fundamental Analysis starts by looking at the health of the market as a whole.  It then looks at individual sectors, and then finally specific companies.

And then: the intrinsic value of those specific companies.

Always keep top of your mind: what would Warren Buffet do? How would he think?

We already know that he views specific companies as either:

• Commodity type businesses
  
• Consumer monopolies

But let's not get ahead of ourselves.  There is a lot of digging you have to do before getting engrossed in specifics.

Let's begin by taking a look at each of the above fundamentals:

1. The market as a whole
2.  Individual sectors
3.  Specific companies within those sectors

Key Point:  taking into account Warren Buffett's views that there are just two type of company - commodity type businesses and consumer monopoly type businesses - this would suggest that he would eliminate the majority of businesses.

"The Dividend Yield"

Before getting into markets in general, sectors and specific companies, you need to know of a few basics about company shares.

Most of this may be obvious to you, but if you are an absolute beginner, then these few items are for you.

You have probably heard of "Dividend Yield" and wondered what it is. Well, wonder no more!

A dividend is that portion of a company's profits that it pays out to its shareholders.  Usually paid twice a year, known as an interim dividend payment and a final dividend payment.

Dividends are announced a few weeks before payment and shareholders on the books at the time are entitled to the payments.  You may have seen share prices in the papers with "xd" after them.  This means that the shares have gone "ex" dividend.

"Ex" is a Latin term meaning "without" and if a person buys the shares after the dividend has been announced, he is not entitled to the dividend.  The previous owner of the share would get the credit.

The term "Dividend Yield" is the percentage rate of the shares return.  Yield is based on the current share price and the current gross (i.e. before tax) dividend.  Dividends are therefore paid to you net of tax.

You will also come across the term "dividend cover"  This is a measure of how many times a company can afford pay the dividend out of earnings.  It is one of many financial ratios that you will discover more about elsewhere on this website.

Generally, the higher the dividend cover, the more secure is the company - but this can also be misleading.  A cover of two, or higher, is reckoned to be safe. 

You will discover elsewhere on this website that a company's Dividend Yield is not necessarily a good measure of the shares popularity.  Different companies have very different ideas when it comes to paying dividends.

Warren Buffett's company - Berkshire Hathaway - has NEVER paid a dividend.

"Understanding the P/E Ratio"

Another, basic financial ratio worth being familiar with is a company's price to earnings ratio, or P/E ratio for short.

Very crudely, a share's P/E ratio is the current share price divided by the latest earnings per share.

Key Point:  Take note that the "simple" P/E ratio uses the latest earnings per share in its calculation.  More clever accounting methods use future earnings per share.

Take for example, Severn Trent (SVT).  Recently, these shares traded at 2,414p

The latest Earnings Per Share  (EPS) were: 66.3p giving a P/E ratio of 36.43

Is this good, or is it not so good? 

You will find out on this website that no one financial ratio, on its own, is conclusive.  They must be used in conjunction with other financial ratios.

Think about it - if it were that easy everybody would climb on that bandwagon.  Clearly not the case.

However, if the P/E ratio is high it usually means that a company is highly rated by the market.  But ... don't be kidded.  The higher the P/E ratio the more expensive the share price will be, which usually means that the share price has already risen to reflect any good news.

Shares with low P/E's on the other hand, could indicate a lack of confidence investors may have in that company.

Finding undervalued stock involves discovering companies with low P/E ratios that have been overlooked by investors.

It is dangerous to take P/E ratios of individual companies in isolation.  It is good practice to compare them with the market as a whole, and with the sectors that they belong to. The P/E ratio is a very useful tool when comparing companies, especially within the same industry. 

For example, if a company is trading with a P/E ratio less than that industry average, it could be a sign that the market will re-rate the shares if it is seen as likely that earnings per share could improve in the future.

Key Point:  Take note that the term "future" earnings is used here and is quite simply the anticipation that earnings might improve in the future.  This is the essence of Value Investing - finding undervalued stock that has been over-looked by investors.

In this section you have been introduced to the terms "latest" EPS, and "future" EPS.  You may also read about "historic" EPS and "prospective" EPS - they are essentially the same terms respectively.

Shares are not valued on what companies earned this year or last year.  They need to look to the future.  Most companies give projected earnings for the future.  Unscrupuless companies will never be forgiven if they over-exaggerate their earnings estimates.

Warren Buffett, on the other hand, goes way beyond.  He likes to project what earnings might be in TEN years' time.  How does he do that?  That, is a topic for a future article - but it will be covered.

"An Introduction To Stock Market Indices"

Stock Market Indices measure the performance of a basket of individual stocks.

Indices are the standard by which you can measure your investments' performance.

In the UK, the main yardstick is the FTSE 100 Index.  You should compare how your investments are performing against this Index. 

Yes, it's relatively new - introduced in January 1984 - but is now accepted as the  "industry standard."  You should compare your shares relative to the FTSE-100.  Good software can do this for you in a heartbeat.

The FTSE-100 Index is, in our opinion, just about a fair reflection on the market as a whole.  It is a collection of the top 100 companies, by market capitalisation, and is up-dated electronically in real-time.  Some would argue that it is an unfair representation of the market  becuase it only comprises of 100 companies and a large proportion of them make their earnings overseas.

Some may argue that the FT-Actuaries All-Share Index would make a truer representation.  In terms of this index containing all UK shares, then yes, it might at first glance appear to be a fairer yardstick but the words "market capitalisation" say it all.

And, for the type of company we will be interested in it covers 90%+ of what this website is about.  This website only encourages investing in high market cap. shares - preferably £500 Million or greater.  That would mean some constituents of the FTSE-250 Index would fit that criteria - but in the main - the criteria set out on this website would probably be the top 150 to 200 shares traded on the London Stock Exchange.

The Dow Jones Industrial Average (DJIA) is another index to keep an eye on.  The U.S. is the biggest Stock Market in the world but the DJIA represents only the top 30 US shares. Incredible, and some think the U.K.'s 100 index is unfair!

A better index to use in the U.S. would be the S&P 500 Index.  As its name implies, it has 500 constituents, in our view, a far better representation of the market.

Our contention is that because these larger indices are made up of very large multi-billion dollar companies, you may happen upon days when these larger companies are going up, yet the majority of shares, i.e. the mid caps and small caps are going down. If you merely looked at the Index you would think that shares, in general, are going up. When in fact, the majority are heading south. Just be cautious.  Look for medium and long-term trends.

As big as the U.S. market is, we will primarily cover U.K. stocks on this website.  But we wouldn't want to ignore the U.S. market totally, it has such a big influence on our market.

In conclusion, the FTSE-100 is our Index of choice.

"The Market As a Whole"

It is important when looking for undervalued stock to consider the overall market.  Things like: general economic activity, gyrations in the business cycle, inflation, unemployment, productivity, etc.

You may not understand the working of the economy but the markets do. There are many factors that affect the business cycle.  Here are three of them:

1. Money Supply Figures.  This is a measure of how much money is in the economy at any given time. If money supply is growing it means that cash and bank deposits are rising and therefore a risk of higher inflation. The UK Government may step in and raise interest rates to try and curb this.  This will affect the Stock Market.

2. The Public Sector Borrowing Requirement (PSBR). This is the amount of money the Government must borrow to meet the difference between its income and expenditure.  If the PSBR increases too fast then the Government might have to print more money or raise taxes.  Either way, the Stock Market will take a view.

3. The Balance of Payments. This is a measure of the difference between imports and exports. These trade figures, affect the Stock Market and also interest and currency rates.

The Business Cycle

The Business Cycle fluctuates from "boom" to "bust" as shown in the diagram to the left.

In the first phase the economy begins to grow. Then it runs out of steam and peaks.

Then there is a downward phase - sometimes it is called a recession phase, but not always. If it is serious, a slump could ensue.

Eventually, the cycle will bottom out, and recovery will set in.  And the wholecycle repeats itself. 

No cycle is identical to the previous ones, but the pattern is always the same.

"Individual Sectors"

Specific sectors need to consider costs, competition, business cycles, industry regulations, labour relations, and, and, and.

The U.K. Stock Market allocates individual shares to a particular sector such as Retailers, Banks and Finance, Pharmaceuticals, Chemicals, Oil and Gas.  Currently there are 37 different market sectors.

Take a look at Stock Market Sectors for a more detailed view

"Specific Companies Within a Specific Sector"

When considering companies within a sector good research involves delving into what the company does, how it works, the quality of management, future earnings, accounting policies, marketing, research and development, and so on.

The ultimate aim of this website is finding those individual stocks that are undervalued and ready for a re-rating by the markets.

They are out there.  It's just a matter of weeding them out.  It requires a systematic approach.  We take no credit for what you will be discovering in this series of articles - it is all based on the genius of Warren Buffett.

If you really want to model yourself after this great man - the first quality you need to acquire is patience.  Warren Buffett is reknowned for his patience.  Sometimes he may idetify acompany as being cheap, but waits until he can buy them at a favourable price.

Sometimes that wait is months - or even years.  But he is looking 10 years and more, into the future.  He knows, that by being patient, the right opportunity will come. 

He has said: "Be fearful when people are greedy, and be greedy when people are fearful."

You will soon come to realise how profound those words really are.

Conclusion

This follow-on article has delved a little deeper into the topic of Fundamental Analysis.

It has hardly mentioned Technical Analysis.  There is a very good reason for that.

Remember what we keep mentioning ad nauseum?  We use Fundamental Analysis to tell us what to buy and Technical Anlaysis to tell us when to buy.

The answer is right there.  You need to know what to buy first and foremost.  Your fundamental analysis will lead you there but it is a lengthy process.

Rome wasn't built in a day. Right?

In this article you have found a little information on Dividend Yield, Earnings Per Share, P/E ratios, and Stock Market Indices.  Further articles on this website will give you much more in-depth information on these topics - all leading to finding that Holy Grail of investing - the undervalued stock.

It has to be said one more time - Value Investing is strictly for the long-term investor.  It is has never been - nor will it ever be - for get rich quick merchants.

The next article in this mini-series will discuss more about a share's intrinsic value and introduce a few more financial ratios.

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