Like many investors, I’m always on the lookout for cheap shares on the stock market. But when I say ‘cheap’, what I’m really saying is ‘meaningfully undervalued’.
Buying undervalued stocks is the core principle of value investing — a strategy used by successful investors including Warren Buffett. And this strategy has been proven to outperform indices decade after decade.
But finding undervalued or ‘cheap’ stocks isn’t always easy. So here’s three tips investors can apply when trying to finding them.
Don’t follow the crowd
A sure-fire way to ensure we’re not buying an undervalued stocks is following the crowd. Because when investors pile into a stock, the price goes up and the valuation metrics become increasingly less favourable.
To this end, Buffett says “be fearful when others are greedy and be greedy when others are fearful.”
This is why investors should look at parts of the market that are not receiving much attention. This is where we are more likely to find shares with more attractive valuations.
The same can be applied to bear markets. When the crowd is pulling out, we’re more likely to be able to find these undervalued stocks.
Focus on Europe
We’re investing in an increasingly uncertain environment in which macroeconomic data, such as jobs reports, and Fed minutes, can swing markets one way or another. But US stocks appear more vulnerable than their European peers right now.
One reason for this is relative valuations. Stocks on the S&P 500 trade with a price-to-earnings around 19, on average. Meanwhile, stocks across European markets, including the FTSE, trade closer to 13. European stocks don’t have that much to lose.
In previous months, analysts would have suggested part of the reason for this is the relative strength of the US economy. But in the medium term, there’s not much between US and European forecasts.
Moreover, in Q4, European stocks demonstrated that the macroeconomic environment was not a hinderance, with many upside surprises. Do European stocks deserve to trade at this discounted rate? I don’t think so.
Do research
Well, as investors we can either follow Buffett — but I’m anticipating his US-focused portfolio to shed some value this year — or we can do our own research.
It might sound unnerving, but it’s not that hard. We can start with near-term metrics such as the price-to-earnings ratio and the enterprise-value-to-EBITDA ratio. These metrics can be compared against companies in the same sector. That way we can develop an idea of relative valuation.
And this can be followed up with further research. For example, housebuilder Persimmon often trades at a premium to its peers because it has achieved higher gross margin on its land bank, in turn driving improved returns.
Finally, there’s the discounted cash flow calculation. This requires us to make estimates about a company’s cash flows over a five or 10 years, and that can be challenging. Thankfully, other analysts do publish their own cash flow forecasts online.
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James Fox has positions in Persimmon Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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