why stocks become undervalued
if you don t believe in the efficient market hypothesis you can identify reasons why stocks might be trading below their intrinsic value here are a few factors that can drag a stock s price down and make it undervalued sometimes people invest irrationally based on psychological biases rather than market fundamentals when a specific stock s price is rising or when the overall market is rising they buy they see that if they had invested 12 weeks ago they could have earned 15 by now and they develop a fear of missing out conversely when a stock s price is falling or when the overall market is declining loss aversion compels people to sell their stocks so instead of keeping their losses on paper and waiting for the market to change directions they accept a certain loss by selling such investor behavior is so widespread that it affects the prices of individual stocks exacerbating both upward and downward market movements and creating excessive moves a bubble is the result of investor exuberance with prices growing ever higher when the market reaches an unbelievable high it usually results in the bubble bursting because the price levels are unsustainable investors end up panicking and selling off related assets en masse this results in a market crash that s what happened in the early 2000s with the dot com bubble when the values of tech stocks shot up beyond what the companies were worth we saw the same thing happen when the housing bubble burst in 2006 and the market crashed in the following years look beyond what you re hearing in the news you may find really great investment opportunities in undervalued stocks that may not be on people s radars like small caps or even foreign stocks most investors want in on the next big thing such as a technology startup instead of a boring established consumer durables manufacturer for example stocks like meta formerly facebook apple and google are more likely to be affected by herd mentality investing than conglomerates like proctor gamble or johnson johnson even good companies face setbacks such as litigation and recalls however just because a company experiences one adverse event doesn t mean it isn t still fundamentally valuable or that its stock won t bounce back in other cases there may be a segment or division that puts a dent in a company s profitability but that can change if the company decides to dispose of or close that arm of the business analysts do not have a great track record for predicting the future yet investors often panic and sell when a company announces earnings that are lower than analysts expectations but value investors who can see beyond the downgrades and negative news can buy stock at deeper discounts because they can recognize a company s long term value cyclicality is defined as the fluctuations that affect a business companies are not immune to ups and downs in the economic cycle whether that s seasonality and the time of year or consumer attitudes and moods all of this can affect profit levels and the price of a company s stock but it doesn t affect its long term value value investing strategiesthe key to buying an undervalued stock is to thoroughly research the company and make common sense decisions value investor christopher h browne recommends asking if a company is likely to increase its revenue via the following methods browne also suggests studying a company s competitors to evaluate its future growth prospects but the answers to all of these questions tend to be speculative without any real supportive numerical data simply put no quantitative software programs are yet available to help achieve these answers making value stock investing somewhat of a grand guessing game for this reason warren buffett recommends investing only in industries you have personally worked in or whose consumer goods you are familiar with like cars clothes appliances and food one thing investors can do is choose the stocks of companies that sell high demand products and services while it s difficult to predict when innovative new products will capture market share it s easy to gauge how long a company has been in business and study how it has adapted to challenges over time for our purposes insiders are the company s senior managers and directors plus any shareholders who own at least 10 of the company s stock 3 a company s managers and directors have unique knowledge about the companies they run so if they are purchasing its stock it s reasonable to assume that the company s prospects look favorable likewise investors who own at least 10 of a company s stock wouldn t have bought so much if they didn t see profit potential conversely a stock sale by an insider doesn t necessarily point to bad news about the company s anticipated performance the insider might simply need cash for any number of personal reasons nonetheless if mass sell offs are occurring by insiders such a situation may warrant further in depth analysis of the reason behind the sale at some point value investors have to look at a company s financials to see how its performing and compare it to industry peers financial reports present a company s annual and quarterly performance results the annual report is sec form 10 k and the quarterly report is sec form 10 q companies are required to file these reports with the securities and exchange commission sec 4 you can find them on the sec website or the company s investor relations page on their website 5you can learn a lot from a company s annual report it will explain the products and services offered as well as where the company is heading financial statementsfinancial statements are generally included in a company s financial reports to regulators but they provide a big picture view of the company s financial condition there are three statements publicly traded companies are required to file the balance sheet the income statement and the statement of cash flows the balance sheet consists of two sections one listing the company s assets and another listing its liabilities and equity the assets section is broken down into a company s cash and cash equivalents investments accounts receivable or money owed from customers inventories and fixed assets such as plant and equipment the liabilities section lists the company s accounts payable or money owed accrued liabilities short term debt and long term debt the shareholders equity section reflects how much money is invested in the company how many shares are outstanding and how much the company has in retained earnings retained earnings is a type of savings account that holds the cumulative profits from the company retained earnings are used to pay dividends for example and are considered a sign of a healthy profitable company the income statement tells you how much revenue is being generated the company s expenses and profits looking at the annual income statement rather than a quarterly statement will give you a better idea of the company s overall position since many companies experience fluctuations in sales volume during the year the statement of cash flows lists everywhere cash came from and went to in a company it tells you which activities created inflow such as operating investing or financing activities it also lists which of these activities created outflows studies have consistently found that value stocks outperform growth stocks and the market over the long term couch potato value investingit is possible to become a value investor without ever reading a 10 k couch potato investing is a passive strategy of buying and holding a few investing vehicles for which someone else has already done the investment analysis i e mutual funds or exchange traded funds in the case of value investing those funds would be those that follow the value strategy and buy value stocks or track the moves of high profile value investors like warren buffett investors can buy shares of his holding company berkshire hathaway which owns or has an interest in dozens of companies the oracle of omaha has researched and evaluated risks with value investingas with any investment strategy there s the risk of loss with value investing despite it being a low to medium risk strategy below we highlight a few of those risks and why losses can occur many investors use financial statements when they make value investing decisions so if you rely on your own analysis make sure you have the most updated information and that your calculations are accurate if not you may end up making a poor investment or miss out on a great one if you aren t yet confident in your ability to read and analyze financial statements and reports keep studying these subjects and don t place any trades until you re truly ready one strategy is to read the footnotes these are the notes in form 10 k or form 10 q that explain a company s financial statements in greater detail the notes follow the statements and explain the company s accounting methods and elaborate on reported results if the footnotes are unintelligible or the information they present seems unreasonable you ll have a better idea of whether to pass on the stock there are some incidents that may show up on a company s income statement that should be considered exceptions or extraordinary these are generally beyond the company s control and are called extraordinary item gain or extraordinary item loss some examples include lawsuits restructuring or even a natural disaster if you exclude these from your analysis you can probably get a sense of the company s future performance however think critically about these items and use your best judgment if a company has a pattern of reporting the same extraordinary item year after year it might not be too extraordinary also if there are unexpected losses year after year it can be a sign that the company is having financial problems extraordinary items are supposed to be unusual and nonrecurring also beware of a pattern of write offs earlier sections of this tutorial have discussed calculating various financial ratios that help investors diagnose a company s financial health there isn t just one way to determine financial ratios which can be fairly problematic the following can affect how the ratios can be interpreted overpaying for a stock is one of the main risks for value investors you can risk losing part or all of your money if you overpay the same goes if you buy a stock close to its fair market value buying a stock that s undervalued means your risk of losing money is reduced even when the company doesn t do well recall that one of the fundamental principles of value investing is to build a margin of safety into all your investments this means purchasing stocks at a price of around two thirds or less of their intrinsic value value investors want to risk as little capital as possible in potentially overvalued assets so they try not to overpay for investments conventional investment wisdom says that investing in individual stocks can be a high risk strategy instead we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors however some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks as long as you choose stocks that represent different industries and different sectors of the economy value investor and investment manager christopher h browne recommends owning a minimum of 10 stocks 6 according to benjamin graham you should look at choosing 10 to 30 stocks if you want to diversify your holdings 7another set of experts though say differently if you want to get big returns try choosing just a few stocks according to the authors of the second edition of value investing for dummies they say having more stocks in your portfolio will probably lead to an average return 8 of course this advice assumes that you are great at choosing winners which may not be the case particularly if you are a value investing novice it is difficult to ignore your emotions when making investment decisions even if you can take a detached critical standpoint when evaluating numbers fear and excitement may creep in when it comes time to actually use part of your hard earned savings to purchase a stock more importantly once you have purchased the stock you may be tempted to sell it if the price falls keep in mind that the point of value investing is to resist the temptation to panic and go with the herd so don t fall into the trap of buying when share prices rise and selling when they drop such behavior will obliterate your returns playing follow the leader in investing can quickly become a dangerous game example of a value investmentvalue investors seek to profit from market overreactions that usually come from the release of a quarterly earnings report as a historical real example on may 4 2016 fitbit released its q1 2016 earnings report and saw a sharp decline in after hours trading after the flurry was over the company lost nearly 19 of its value however while large decreases in a company s share price are not uncommon after the release of an earnings report fitbit not only met analyst expectations for the quarter but even increased guidance for 2016 9the company earned 505 4 million in revenue for the first quarter of 2016 up more than 50 when compared to the same time period from one year previous further fitbit expected to generate between 565 million and 585 million in the second quarter of 2016 which was above the 531 million forecasted by analysts 9the company looked to be strong and growing however since fitbit invested heavily in research and development costs in the first quarter of the year earnings per share eps declined compared to the previous year this is all average investors needed to jump selling off enough shares to cause the price to fall however a value investor who looked at the fundamentals of fitbit understood it was an undervalued security poised to potentially increase in the future case in point in 2019 fitbit posted more than 1 4 billion in revenues then in 2021 google finalized its purchase of fitbit for 2 1 billion 1011 a value investor purchasing fitbit stock at an undervalued price of 5 35 on feb 9 2017 would have done well because the stocks were converted to cash at a value of 7 35 per share at the merger and paid to investors 1213