Why Do Stocks Get Cheap?

What causes stocks to become cheap?

This is one of the most fascinating questions about the stock market. With literally millions of investors scanning the market for opportunities, a near-instantaneous flow of information, and financial reporting better than ever, how is it that stocks can become mispriced with such regularity? Speaking very generally, it's because investors do not always behave rationally--they have emotions and biases that affect their decisions.

If you can identify these biases and relate them to specific investment opportunities, you'll have an advantage over the crowd. In other words, it's not enough to analyze a stock and come to the conclusion that it's undervalued. You need to ask yourself why it's undervalued--what has caused other market participants to price the stock at what you think is an irrationally low level? If you can't come up with a reason, the stock might not be as cheap as you'd thought.

I made a list of four common "mispricing categories" in a previous column, and I'll push the topic further. My own investing has improved since I started pushing myself to think about why the stocks I buy are not being valued properly by the market. Sure, I'm still wrong more often than I'd like, but I've also managed to avoid a few stinkers because the stock looked cheap, but I couldn't figure out why it was cheap.

It's Right Under Your Nose
This one doesn't happen often, but occasionally stocks can quietly become cheap. If a company's share price goes sideways for some years while the business continues to chug along, the valuation steadily becomes more attractive. How can this happen without the market noticing? Well, for one thing, stocks that don't move a lot (up or down) don't generate much news, and with thousands of stocks to watch, many money managers rely on the headlines to bring stocks to their attention. So businesses can just chug along under the radar, even when they're pretty sizable.

A contributing factor is that Wall Street generally goes with "what's working now," which means that some stocks might be cheap just because they're not in vogue. This happened with small caps and REITs--among other areas--when nothing but mega-caps and tech were going up in the late 1990s, and I think the same thing has been happening with large caps over the past few years. After a lengthy stretch of strong small-cap performance, many investors were projecting the recent past into the future and buying "what works"--small caps--rather than looking for bargains among large caps. (This may be starting to change, but only just.)

I call these "purloined letter" stocks, after the Edgar Allen Poe story in which an important letter was hidden from the police in plain sight by simply being crumpled up as if it were unimportant. Consider  Coke (KO),  Johnson & Johnson (JNJ), and  Wal-Mart (WMT). Over the past five years, Coke and Wal-Mart shares are down by one third and by about 10%, respectively, while J&J's stock has risen about 20%. But J&J is generating 70% more cash from operations than it was five years ago, Coke's cash flow has risen 80%, and Wal-Mart's cash flow has doubled. They're bargains in plain sight that are mispriced simply because Wall Street has been too busy chasing China plays and energy stocks.

The Smell Is Bad
Stocks that have a "taint" are often priced irrationally. This was the case with Philip Morris (MO) (now  Altria) for years, and you also often see it with companies that are emerging from bankruptcy. How could  K-Mart  have been so cheap when it re-emerged from bankruptcy? Because most investors didn't want to bother with a stock that had only recently risen from the dead.

I think this is one of the reasons why  J.P. Morgan Chase (JPM) is so attractively priced right now. Investors hear the word "derivatives" and run screaming for the hills despite the fact that the more-exotic derivatives account for a single-digit portion of the firm's equity. Moreover, the vast majority of the firm's counterparties have credit ratings of BBB or above, which makes default pretty unlikely. So is Morgan's derivatives business a risk worth keeping an eye on? You bet. Is it enough of a worry for the shares to merit a price/book ratio of just 1.3? Nope.

Guilt by Association
Finally, you often see good companies in tough industries mispriced because investors tar them with the same brush as their less-attractive peers. The steel industry has gotten a bad rap from many investors who associate it with giant pension costs, crushing debt loads, bankrupt firms, and industry overcapacity. In most cases--particularly for U.S.-based integrated steel companies--this is an accurate assessment.

However, when you look at a company like  Gerdau (GGB) in Brazil--with access to incredibly cheap hydroelectric power--or  Posco (PKX) in Korea--with a virtual monopoly in the Korean market--you see firms that can be pretty attractive investments despite their tough industry environment. Gerdau has a 1-star rating and Posco is at 4 stars, but  we currently have a 5-star rating on  Mittal Steel (MT), the world's largest steel firm. Steel is a tough industry, but not tough enough that a company with a fully funded pension plan, an investment-grade credit rating, and dominant market positions throughout the world can't offer an attractive return when it's priced at just 5 times earnings.

This article originally appeared on Nov. 11, 2005.