It is said that by the age of 10, Warren Buffett had read all of the books in the Omaha Public Library with the word finance in the title. Because he loved reading about finance so much, he read some of the books twice. Today, if you were to share a private jet with him, he’d exchange pleasantries and then begin reading.
Today’s post shows you one of the ways that I look for undervalued stocks using a real example that does not use a screener.
Don’t get me wrong, I’m not denouncing screeners. In fact I still use them as a way to find undervalued stocks. It’s just that I like reading and interpreting financial information and data from primary sources. More importantly screeners have limits. For one thing screeners use metrics that rely on data from the balance sheet such as price to tangible book value which may not be entirely accurate due to off balance sheet liabilities such as operating leases:
an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and, more importantly, the liability – investopedia.com
The bottom line is that you have to do your homework if you want to find an undervalued stock. No one is going to tell you about undervalued stocks.
How do you avoid inaccurate intrinsic valuations? How do you go about finding stocks that are undervalued? Is there are systematic way of intrinsic valuation that does not use a screener?
The answer is to sift through the daily list of 52 week lows until you find an undervalued company. But that is a rather vague explanation.
They say that good companies with strong balance sheets that pay dividends that have competent management and have a history of earnings growth are sometimes mispriced by the market. This happens for short periods at a time which means that the best way to find undervalued companies is to look at companies on a daily basis that have suffered price declines. Quite large ones. Since there are more companies that are fairly valued than those that are undervalued, there needs to be an efficient way of eliminating those that are fairly valued from your research process in order to concentrate your time and due diligence on potentially undervalued stocks.
I’ve analysed thousands of US and UK equities and have come up with a way of quickly eliminating fairly valued or overvalued stocks. Before I share how I do this, let’s dive straight into an example from today’s list of 52 week lows from The London Stock Exchange.
Is Amara Mining Undervalued?
Here is a long-term price chart of UK small cap Amara Mining (AMA):
As you can see, it’s been on a rather choppy price decline since the first quarter of 2011. But notice how Amara’s share price went down to 12p in 2008. This is significant because it could quite easily go down to that price again which could be an indication that at the current price, it’s overvalued or at least may not have an adequate margin of safety.
But this is technical analysis. What about the numbers? Here are 13 basic value metrics that I use applied to Amara:
- P/E Ratio: 4.48
- Price to Net Tangible Asset Value: 1.60
- Price to Cash Flow: 1.72
- Debt To Equity (excl. intangibles): 0.20
- Current Ratio: 2.81
- Net Profit Margin: 10.18%
- Return On Capital Employed: 20.96%
- Return On Assets: 9.43%
- Return On Equity: 11.40%
- Dividend Yield: 0.00%
- 3 Year Earnings Growth: Negative
- 5 Year Earnings Growth: Negative
- 10 Year Earnings Growth: Negative
Figures are from ADVFN
Not stunning on the earnings front which is why they do not pay a dividend. This has given me my second and third causes for concern.
Switching to the Investigate website and punching in Amara’s ticker (AMA), 3 public announcements immediately catch my eye:
- A notification of a major interest in shares which basically tells me that Sprott Asset Management dumped 500,000 shares on 28 January 2013 which is approximately 100% of its average daily volume.
- A 2012 production report for Kalsaka Mine (it’s only profitable mine) which is surprisingly upbeat even though production in gold and ore is down from the year before
- A grant of options on 10 January to the Executive Chairman of 319,520 to bring his total to 2,000,000, to the Chief Executive Officer 1,250,000 to bring his total to 1,750,000 and to the Finance Director 1,250,000 to bring his total to 1,750,000. It is a combined total of 2,819,520 options that have been granted.
GAME OVER 🙁
Do you notice anything about the way I researched Amara? The 13 basic value metrics alerted me to a problem with earnings straight away. The research was relatively quick (less than 10 minutes) and included three key questions to focus on which were:
- what are people who are smarter than me are doing with this stock (selling)
- what is the state of business operations of the company (poor) and;
- how well are shareholders being treated by management (poorly).
The results of this analysis does not make me want to research this company further or buy stock of this company. It does not even make me want to place it on a watchlist as there are too many negatives associated with this company. No margin of safety.
This same process
can should be applied to every stock you are interested in valuing whether it’s from a list of 52 week lows, a news article that you’ve read or any source that inspires you to start the valuation process.
How To Ensure That Valuing A Company Is Irrelevant
It will be impossible for you to build a portfolio of undervalued stocks if you read this post but forget one vital element to a value investor’s weaponry. If you don’t have a written and tested investing strategy against which you can evaluate each stock, then it’s pointless conducting a valuation in the first place.
A list of 52 week lows is there to provide you with a convenient daily list of stocks that you can do an initial appraisal on. Many professional investors use this list to generate ideas for investments in the same way.
If I’m going to buy a stock, then I need some idea of what I’m looking for from a value orientated perspective. I can’t just say I’ll buy stocks that have a low PE ratio. Amara has a low PE ratio but it is not an undervalued stock as of today’s date. I literally have to look for evidence that a stock exhibits a collection of value characteristics each and every time and on every stock I purchase for my portfolio.
Some of you may think that all of this is BS and that finding undervalued stocks requires a university education or some special sauce that only a select few have access to. Or maybe you think your stockbroker or financial journalist would be more qualified than you to find undervalued stocks. Well I’m calling BS on that way of thinking.
Now you know how to find undervalued stocks, you’ll need to think about and write down your own value investing strategy that is personal to you. Don’t try to copy me or anyone else because you’ll be copying my biases and shortcomings.