"Undervalued Stocks Are The Holy Grail of Investing.  They Are What Warren Buffett
Spends All His Research Time Looking For"

Introduction

Undervalued Stocks are the Holy Grail of investing.  Find them, and you can book your ticket to early retirement.

In a previous article, Stock Market Explained it was described that there are three factors that govern the performance of company shares:

1. Psychological Factors

2. Fundamental Analysis

3. Technical Analysis

In this follow-up article, each of those three factors will be expanded upon in more detail.

It was also touched upon how most private investors behave in large groups, sometimes referred to as "the herd" or "the crowd." They are the ones that think they are good because they buy in a rising market, they may be that new to stock investing that they have yet to experience a Bear Market.

And those that do remember a falling market tend to have very short memories.  

But the difference between an investor and a speculator is in the type of stock that is bought. Investors are in the market for the long haul.  Speculators are in for short term gains.

An investor does his research.  A speculator buys on a hunch or takes tips from people who know even less than him.

The key - and always has been (and always will be) - is to research company shares that have been oversold, and thus undervalued, by the market.  Sooner or later, this type of share will re-assert itself and your research and patience will be rewarded.

This website follows Warren Buffett as closely as possible.  He is a master at finding undervalued stocks.

"The Type of Investor You Need To Be
If You Are Trying To Find Undervalued Stocks"

Everybody wants to be successful trading the markets but will they be?

Most of time, investors lose money because they are too emotional (and impatient). Most beginners are always looking for that "quick buck."  Buy a share that hardly anybody has heard of and sell it the next day for a quick "turn".

That rarely happens, and when it does, it is usually pure luck. Most investors of this type lose money.  Sometimes a lot of money.  Enough to put them out of the game.  Some even go bankrupt.

If you want to make quick profits then stop reading right now and look elsewhere.  You will not find any "get rich quick" strategies on this website.

That brings us to the first quality in a good investor and one reason why markets fluctuate the way that they do:

Know thyself.

Consider yourself as your own financial advisor - which you are.  If a "professional" advisor were to look after your finances he would be legally bound to question you in regard to your financial standing. Only after doing that will he (or she) be able to advise you accordnigly.

But you are going to be your own financial advisor so ask yourself those questions.  Take the time out to analyse your situation and needs until you get to what is right for you.

You need to grill yourself on what type of investor you want to be.  For example: are you the conservative type or the willing-to-take risks type?  Are you looking for income, or capital appreciation, or both?

If you want to be a "buffettologist" then the type of investor you want to be will be a "value investor" and a little bit of a "growth investor".  You may want to add a little bit of "momentum investor" as well.

Don't concern yourself right now if you don't know what these terms are - you soon will.

Remember also, that you are saving for your retirement and, depending on your age, may depend on the type of investor you want to be.

The whole tone of this website is that it does not matter what age you are, your goals should be the same.  The only difference being that the older you are, the less time you will have.

Traditional advisors have taken the attitude that as you get older, you should reduce your risk.  But this website does not subscribe to that view. Why do you think that might be?

The answer to that question would be jumping the gun a bit, but briefly, the type of company share you will be investing in will not be risky.  If you stick to the W.B.M. (Warren Buffett Method), you will only be investing a good, solid companies that prosper year in, year out.

The only "enemy" you will have is time.

In fact, the only question you should be asking yourself is this: why wouldn't I want to invest like Warren Buffett?  He is always on the look-out for undervalued stocks.

"Why Most Investors Fail"

Do most investors fail?

That depends on your definition of "investor"

For now, let's class an investor as a member of "the herd."  In which case it's more likely that he will have a few successes but overall he will fail.  Why?  Because they understand the concept of rising markets, where they can't help but make money but just cannot get their head around falling markets. Panic sets in.

Buying Climax

The diagram shows that in a rising market (as shown by the ever rising price bars on the left) investor buying keeps pushing the price higher and then those that think they might miss out pile in - as shown by the increase in volume.

Unfortunately, and unwittingly for them, the smart marketers are getting out.  The buying dries up, the price has nowhere else to go - except down.

Markets are full of overvalued stocks.

Selling Climax

And the same thing happens on the downside.  Prices start to slip.  Those investors that got in the market near the top see their short term profits slip but hang on in the hope that prices will recover.

They don't.  And further down they go.  These investors are now faced with a loss, and are reluctant to take it.  But the price goes down even further - now they are really losing money.  But they still hang on in there - they just don't know what to do.

Alas, the market goes down further still.  These buyers at the top of the market now think the market is going to crash.  They sell (as shown by the falling bars and high volume near the bottom).

But in fact, the market is now getting ready for its next up-move.  Markets are full of undervalued stocks.

That is a typical scenario of how naive investors lose money.  It's also a typical scenario of how smart investors make money - they have seen it all before.

The point is, if you want to invest the W.B.M. then the above scenario will never happen to you. Even if you were to "get in" at, or near a top (which would be extremely unlikely), you would know how to read the situation and hold for the long term.  You would have done your research on the company and found that it is rock solid and not about to disappear into oblivion.

Warren Buffett does not stop in his research until he finds undervalued stocks, and then he waits patiently until they are ready to buy.

"Finding Undervalued Stocks"

Benjamin Graham believed that stock markets were made of up two components:

• The first one being long-term investment oriented, meaning that over time the market price of a company's stock would reflect its intrinsic value
  
  
• The second one being people treating the markets as some kind of casino (i.e. gambling), causing short-term fluctuations in price

He firmly believed that the gambling component dominated in how the markets moved, especially on a daily basis with good and bad news affecting prices.

He concluded that it was this gambling effect that allowed the patient investor to enter (and exit) the markets at the right time and price.  He reckoned that as long as fear and greed dominated markets, smart investors (i.e. long term investors) would always have opportunities to get in at prices below their intrinsic values and pick up undervalued stocks.

Warren Buffett agreed with this analysis in principle, but modified it to suit his own style.

We like it too, but believe that Monentum Investing and Technical Analysis should be used as well.

So how do you begin to look for undervalued stocks?

It's not that simple.  Warren Buffett does hours and hours (make that weeks and weeks) of research before he decides what to buy.

It all starts with a look at the fundamentals.

"Fundamental Analysis"

The type of investor you are going to be will rely on three levels of information:

1. Economic Factors

2. Trends

3.  Specific Factors

Every share has a price - the price that someone is willing to pay. All shares become either under-priced or over-priced.  If a market is "efficient" a share will find its true value.

To make money in the markets, you need to be able to find the shares that are under-valued and avoid shares that are over-valued.

But what is an "efficient" market? 

In an efficient market, prices change due to basic factors such as company earnings and the general economic outlook.  But all this information is available to everybody which would mean that nobody has an advantage - all the information would be already built in the price.

There is an alternative to the "efficient" market theory and that is the "random walk" theory. This is the belief that share prices, at least in the short term, behave randomly.

Then there is a third factor at work - "insider trading."

It is always good practice to monitor what company directors are doing.  Are they buying their company shares or selling them?  There may be many reasons why a company director is either buying or selling shares and in what quantity?  Maybe they need to raise some cash if they are selling.  Maybe they know something bad is looming?

If they are buying, maybe they know of an impending take-over.  Or some other positive news about to be announced.

Either way, their trading could affect the share price. It is always a good idea to monitor director dealings - they are freely available in the business section of newspapers. There are even newsletters than specialise in reporting such activity.

You can get free access to diretor share dealings by visiting:

www.sharesmagazine.co.uk/director-deals

In conclusion, there are many factors that influence the movement of share prices, especially in the short term.  But, good investors, like Warren Buffett pay little attention to this "noise."  They are always looking for the Holy Grail:

Value.

Or to be more precise: undervalued stocks.

If Warren Buffett spends a lot of time on his research then that is a clue as to what the rest of us should be doing.  We will never have the time or knowledge to do what he does but we can learn some basics and not just select companies to invest in on mere "hunches" or bogus tips.

Fundamental Analysis is one way to find undervalued stocks (Warren Buffett would say it is the only way), but there is a second method and that is with what is termed Technical Analysis.

We like to think that if Funamental Analysis informs us of what to buy (or sell) then Technical Anlaysis tells us when to buy (or sell).

"Technical Analysis"

The FTSE 100 Index

As you can see this is graphical representation of the FTSE 100 Index, dating back to its origin back in 1984.

As it stands, it is not a lot of use except to show that the general trend in price has been up. But not without a few setbacks.

This is the most basic of charts and its only use is to show the overal trend of the market.  More information would be required to make the chart more meaningful.

Such as the number of shares traded, known as volume.  Also, the chart is called a "line" chart, meaning that it only shows the closing prices of the market.

As you have discovered, prices of shares fluctuate daily.  Each individual share will have a high and a low for the day, and a price that it opened at, and a price that it closed at. You can observe a simple bar charts in the images earlier in this article.  

You can see from those images that there are open prices, close prices, price highs,  price lows, and the volumes of shares traded for the given period.

The images show only one period of trading, which could have been any time frame.  One minute, one hour, one day, one week, etc.  Most graphs are built up with daily information  - these are usually called "end of day" charts.

It is logical to view charts with "end of day" information.  Speculators may use charts of shorter duration, but as a reader of this website, you will, for the main, only see end of day information on charts.

A simple bar chart contains a lot of information, which, when looked at accumatively, is very informative to an experienced chartist.  The object of this website is not to make you into a formidable chartist, but to give you an appreciation and understanding of how charts work.

You will discover elsewhere on this website, that volume traded plays a very important part in interpreting a shares movement.

There are many different kind of charts available to the serious techncial analyst, but you will only require an appreciation of them. 

As already mentioned, the bar chart is popular, but there are also: point and figure charts, Dow theory, chart patterns, support and resistance levels, trend channels, and many other aspects of charting will be covered via articles on this website. 

Does "a picture paint a thousand words"?  Is it possible to spot undervalued stocks just by looking at a chart?

The bottom line is ....

"Does Technical Analysis Work?"

Warren Buffett doesn't think so.  He thinks it's a load of mumbo-jumbo.

Yet thousands of investors do make money by trading this way.  One of the greatest investors of all time, William Gann, made four fortunes by trading this way. 

However, Mr. Gann also lost four fortunes.  Good chartists do make money.  But they also lose money.  Their argument being that they win trades more often than they lose them, therefore giving them a net gain.

Perhaps this is why Warren Buffett does not like Technical Analysis.  He likes to win on every trade. Who can argue with him?  He does win on his trades.  That's why he's the world's most successful investor with asets of $90 Billion - and still counting.

We believe in something a little bit in the middle.

We would never buy a company share on the basis of Technical Analysis alone, but we would use it to confirm the price of undervalued stocks.  Even a rank amateur could have an opinion on that.

As we have stated many times: we use Fundamental Analysis to ascertain what to buy and Technical Analysis to ascertain when to buy.

Conclusion

Your first objective is to define the type of investor you want to be.

This website will lean heavily in favour of the W.B.M. (Warren Buffett Method) with a few refinements, such as 'Momentum Investing' and 'Technical Analysis'. Warren Buffett is not a keen advocate of either momentum or technical trading.

Mumbo-jumbo he calls it.

We take a different view.  In most walks of life, if you want to know whether something works or doesn't work - what do you do?  You test it.

We have tested momentum techniques and technical trading and found them both to be extremely beneficial.  If it works for you - don't knock it.

But even we are in full agreement when it comes to undervalued stocks.  They are indeed the Holy Grail of investing. 

Momentum trading won't uncover them for you, it will only help you trade them.  Technical Analysis won't help you uncover them either, but it will help you time your entry and exit points.

Only Fundamental Analysis will help you uncover those golden nuggets.  And to achieve that you will need lots of research, time and patience.  Even when you have found them, you may have to wait a considerable time before it is ripe for you to buy - sometimes months.  Warren Buffett has been known to wait years before buying stocks.

One of Warren Buffett's most gifted attributes is patience.  If you are not a patient person - it's time for you to change.

Technical Analysis will however, help you to confirm that you have indeed found for yourself undervalued stocks.

Look out for further articles as a follow-on to this one.  Look for Undervalued Stock and Undervalued Shares

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