Six Tips for Identifying Undervalued Stocks

In last week's column, I wrote about the different motivations and time horizons among different groups of investors, and how they affect stock prices. I concluded that beauty is in the eye of the beholder, that there's no such thing as a single "fair value" for a company. It depends on who's doing the valuing. This can present opportunities for long-term investors.

Then I asked a question: How can you determine when one of these opportunities is present--that is, how do you recognize the fat pitches? Here are some thought processes I follow.

1. Develop a logical strategy.
Many people think the key to success is to outsmart the market. Although that may be possible for a select few investors, in a reasonably efficient marketplace, this is an illogical strategy--and a recipe for mediocrity. Millions of investors are trying to beat the market, and many of them have access to information that you (or I) don't. In other words, they have more money to buy information. So outsmarting the market by gaining access to more information isn't really an option for individual investors.

But never fear: If access to information were correlated with stock market success, individuals would have no chance of outperforming institutional investors. In fact, if this were the case, it would be illogical for do-it-yourself investors to buy individual stocks at all; mutual funds would always have a higher expected return than any individual's portfolio. Warren Buffett wouldn't have made a dime, and Janus would have gotten out of the market before the bubble popped.

Since this theory obviously isn't true, it seems that the most logical strategy for stock market success is to out-discipline the market, not outsmart it. (This is true for both individuals and institutions.)

Here at Morningstar, we attempt to do just that by following the fat-pitch strategy. In a nutshell, this method involves finding great companies at significant discounts to fair value, and then holding on to them for long periods. If we can't find any stocks that meet this criteria, we twiddle our thumbs and wait. It usually doesn't take very long before a bargain or two will pop up. We don't rely on access to expensive information, just publicly available data such as 10-K reports and proxy statements.

2. Follow a watch list of wide-moat companies whose business models and industries you can understand.
Get familiar with each stock on this list. Read their 10-Ks and, just as important, their proxy statements. If there's something you don't understand, call the investor relations department. Warren Buffett calls this "developing a circle of competence." Start with a small circle, say, 20 companies, and expand it over time. Click  here to see a list of all wide-moat companies covered by Morningstar.

3. Factor out the noise.
On any given day, there will be press releases and articles in the business press about companies on your watch list. How do you know which are important and which aren't? By focusing your attention on just two areas: a company's economic moat, and its corporate governance. Any news that doesn't alter your opinion of a company's long-term competitive position, or the quality of a company's corporate governance, is just noise. Ignore this information--let the short-term traders focus on it. Keep your eye on the ball at all times, the "ball" being the combination of the moat and corporate governance.

4. Get comfortable with your fair value estimate for each watch-list stock.
Remember that two types of news can affect daily stock prices: 1) Noise and 2) Meaningful information that affects a company's moat and corporate governance. If you're a long-term investor, your estimate of a company's fair value should be affected only by the latter. If you're truly taking a long-term perspective, this fair value shouldn't change very often. When a stock falls well below your fair value, buy it.

5. Exploit your inherent advantages.
In investing, patience is a virtue. If you're an individual with a long time horizon, you have a huge advantage over just about all money managers: the ability to wait for the right price. You can exploit the fact that you don't need to be fully invested, or close to it, at any given time. No one will fire you if you hold too much cash in your portfolio while semiconductor stocks go from overvalued to ludicrously valued. Very few fund managers can say that. They are, sadly, forced to throw money into overvalued stocks or risk short-term underperformance, which can be a very bad career move. Meanwhile, you can wait for the stocks on your watch list to pull back before buying them.

6. Be a skeptic, and a rational contrarian.
Consider ignoring the popular press altogether when making decisions on what stocks to buy and sell. If journalists had a proven ability to outperform the market, why aren't they in the money-management business instead? It's much more lucrative.

The same goes for Wall Street analysts: Many of them can't pick stocks to save their lives, even if they're very good at what they're paid to do. You see, analysts aren't hired to pick stocks. They're hired to alert investors to fundamental developments within a company, and to predict what these developments mean for the company's future. (On Wall Street, "future" typically means the next three to 12 months.) Note that I didn't use the word "stock" anywhere in that definition. In general, the skill set required for being an analyst is different than that required for being a stock-picker. You can be a good analyst without being a good stock-picker, but the reverse isn't true.

So, when you notice a stock has been downgraded repeatedly in the last few months, with no upgrades, the odds are high that it is undervalued. The fundamentals may be deteriorating, but that's already priced in, and then some. Especially for wide-moat stocks, when there's a consensus negative opinion among the analysts, it's probably time to buy.

For example, back in February when  Home Depot (HD) was selling for around $21 a share, it had been downgraded several times in the previous few months, with no upgrades. It's up 50% since then. The same was true of  Automatic Data Processing (ADP) when it sold below $30 for a short time in March. It's up about 40% since then. 

If you're an individual investor, don't think you can't beat the pros at their own game. As you can see, it's as much an art as a science. One caveat: To do this well, you'll need to spend a lot of time studying your stocks, tracking them, and thinking about their fair values and economic moats. If you don't think you're up to it, you're not alone. Picking stocks isn't for everyone; that's why there are mutual funds.