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Discovering Underpriced Stocks

May 25, 2023

I have a profound interest in stock investing. It's intriguing, exhilarating, and can be pretty rewarding. But, of course, it also comes with a certain level of risk. I embarked on my stock investing journey in 1988, and over the years, I've become adept at spotting the elements that influence stock prices, both positively and negatively. When asked to describe my investment approach, I would use "value."

To me, "value" signifies the possibility of capital appreciation in the stock market. Value stocks possess strong financial statements, impressive earnings growth, and low price-to-earnings ratios (P/Es). Moreover, these stocks are filtered to minimize risk, leaving a promising opportunity.

Let's dissect what a value stock encompasses.

Key Factors of a Value Stock

Earnings per share (EPS) growth: In the intermediate and long term, a company's earnings growth propels its share price. It's crucial to target stocks with an upward trajectory in earnings. Even though a stock can appreciate with stagnant or even declining profits, stocks with growing earnings have a higher probability of increasing in value. My picks typically have expected EPS growth of 15% or more for the current and upcoming fiscal year.

Investors can use Wall Street's consensus earnings estimates to calculate EPS growth rates.

Note: I don't rely on previous years' EPS. My focus is forward-looking, and I base my decisions on projected EPS.

Price/earnings ratio (P/E): I prefer stocks whose current P/E is less than their EPS growth rate. If a company's earnings are projected to grow by 18% this year, but its P/E is 24, I would label that stock overpriced and steer clear. However, if the P/E were 12, that would pique my interest!

I also consider the P/E for the next fiscal year in relation to the EPS growth rate for the same period. It's futile to purchase an undervalued stock based on this year's earnings if it's overpriced based on next year's earnings.

There are intricacies to the P/E ratio. Many stocks have typical annual P/E ranges, providing insights about whether the stock is underpriced compared to its regular trading patterns. Industry groups also follow specific P/E ranges. Essentially, a stock with a P/E that's low compared to its usual range or earnings growth rate is likely an undervalued stock!

Dividend yield: If dividends matter to you, but you also want capital appreciation, consider this strategy. Add the EPS growth rate to the dividend yield, e.g., 12% + 3% = 15. In this case, you would want the P/E to be less than 15 when screening for underpriced stocks. If the P/E is 14, it might not be an attractive buy. But if the P/E is 11, there is a promising potential for capital gains.

Long-term debt-to-capitalization ratio: I concentrate on stocks with debt ratios below 40%. High debt levels can cripple a company's capacity to invest, innovate, and compete.

If a stock meets my earnings, P/E, and debt criteria, I examine its chart. I prefer stocks poised to rise, not those that are declining, stagnant or have recently experienced a significant surge.

Interpreting stock charts is indeed an art.

The Benjamin Graham Method

The value investing approach of Benjamin Graham, considered the father of value investing, has dramatically influenced my strategies for myself.

Graham's work stood out because he created a systematic method for evaluating companies to find low-risk investments that promise long-term rewards.

Graham advocated analyzing a business based on six metrics:

  • Profitability
  • Stability
  • Earnings growth
  • Financial position
  • Dividends
  • Price history

Graham's concept of Mr. Market, a character he often mentioned in his classes at Columbia University and in "The Intelligent Investor," reminds investors that investors should not let the market's whims dictate their view of their shares' worth. Instead, they should profit from market follies rather than participate in them. As a result, investors should focus more on their companies' actual performance and dividends rather than Mr. Market's often irrational behavior.

Final Thoughts on Underpriced Stocks

Although much of what Benjamin Graham wrote about 75 years ago is still relevant, I've modernized the approach in various ways.

My strategy is a blend of growth and value. Therefore, the growth aspect is reflected in the stringent EPS growth rate requirement, while the value aspect is showcased in the P/E and debt requirements.

The term "value" in the investment world can have many interpretations. Some might associate it with low share prices, unappealing stock charts, or large, slow-moving blue-chip companies with generous dividends and stagnant earnings growth. However, value implies a healthy balance sheet and a share price attractive to institutional buyers and potential M&A offers.

The rigor of my stock selection process is crucial because the figures continually change after stocks are added to my portfolios. For example, suppose the earnings growth rates decrease due to a decelerating business cycle or the P/Es increase due to rising share prices. In that case, I want enough flexibility for the stock to remain underpriced and appealing.

Over time, my growth-and-value approach has proven successful and could result in positive returns. But, remember, no investment strategy and eliminate all risk, and this investment strategy may result in loss. 

If you are looking for a financial advisor to help you make informed decisions about your finances, including doing nothing, let's chat!

The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy
or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on
sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.