Two Ways To Find An Undervalued Stock

The word “undervalued” is one of the most commonly used, yet often undefined, words in investment discussions. The general principle of searching for undervalued stocks is straightforward enough: People that buy undervalued stocks want to find a company that is worth more than the current price of the stock indicates. But the tactics for making this identification differ among the thousands of men and women that dedicate sizable chunks of their life energy to this pursuit.

Charlie Munger said that we all have an obligation to destroy at least one deeply held conviction per year. When I first started studying large-cap stocks, I believed that a stock was undervalued if it traded at a P/E ratio below its historical range. I knew it didn’t apply to fast growing or small firms, but I figured that if Smucker usually trades at 23x earnings and an opportunity arises to buy at 18x earnings, there must be a high probability that the stock is undervalued.

While that is not a terrible process, I much prefer these two methods for identifying a company as undervalued:

Option #1: Find companies where there is a significant difference between what the current and prospective owners of the stock expect and what will actually be achieved by the company.

Option #2: Find companies with great projections into the future that are not adequately priced into the stock because the current and prospective owners of the stock do not have as long of a time horizon.

There is a reason why Warren Buffett loaded up on IBM stock as the price fell from $169 at the time he initiated purchases all the way down to the $140s. It is not that he thought the company would be delivering the greatest earnings per share out of all the publicly available companies that he could get his hands on.

Instead, Warren Buffett acted on the assumption that current prices of stocks already contain expected information, and the low price of the stock assumed perpetually poor business results from IBM. When IBM’s performance over the coming ten years is not as bad as the other investors anticipate, Warren Buffett will make significant money for Berkshire shareholders.

This is one of the two most important insights you can have about Warren Buffett that the popular media generally misses. The first is that Warren Buffett is a stunningly clever strategist who reads the proverbial footnotes and pays as much to the tax structure of deals as the actual companies purchased. The second is that he is the master of identifying market expectations for companies (we often call these “consensus earnings estimates”) and then making investments based on when he thinks there is a sizable gap between future reality and current expectations. It is not absolute growth he follows, but the difference between actual future growth and estimated future growth, that drives his investment thought process.

The second way to find undervalued companies involves having a longer holding period than the typical investor that purchases the stock. Seth Klarman frequently calls this the one “enormous advantage” that the individual investor has over professional investors. It is not something to discard lightly, and you should arrange your affairs so that you can make decisions with 10+ year time horizons.

The obvious example of this phenomenon is the oil sector. I think everyone knows that Chevron, Exxon, and Royal Dutch Shell will be worth significantly more 25 years from now. The cash payouts from those three enterprises in year 25, compared to the amount of capital invested in year 1, will be enormous. But many professional investors have had to worry about displeasing their clients in the short term due to relative underperformance or the wild swings in the prices of oil stocks, and they cannot commit to owning the company for decades let alone years. This is the advantage to seize.

Other times, the insights are more company specific. I don’t say this lightly, but Lockheed Martin has been quietly moving onto my list of Top 40 Companies in the entire world when analyzed according to a combination of current earnings quality and future growth prospects. Yes, the P/E ratio is always a bit higher than seems comfortable, but there is a reason why this stock has been able to deliver 16.5% annual returns since 1977.

Part of the reason is that company benefits from ever-escalating defense budgets and enormous gross profits on every piece of weaponry and aerospace machinery that gets produced, but there is also a patent angle. Lockheed Martin owns a tremendous amount of patents that stand to transform the production of oil and natural gas in the years ahead. These take years and years to materialize. Being able to sit on your rear, collect Lockheed dividends, and wait for the patents to turn into new subsidiaries is a tremendous business advantage. Even if the P/E ratio is high, the stock may be undervalued if you see an edge that delivers superior growth over a longer holding period than the other stock market participants currently contemplate.

It is important to remember that we never benefit from yesterday’s growth. If you make an investment, you can realize immediate rewards from the current operations such as when a Philip Morris International shareholder collects large quarterly dividend payouts immediately. But the other rewards come from the extra capital appreciation when market expectations are exceeded and adjusted upward, as well as being able to hold on for the truly long term to realize growth projects that the market never fully priced in because of the project duration. You make an undervalued investment when you find enterprises that will exceed market expectations or have a holding period long enough to see far off but highly certain growth initiatives materialize. Those are my two techniques for identifying undervalued assets.