If you find a stock that you believe is undervalued, it is important to try to determine the reason for the undervaluation. As Buffett wrote about poker in his 1987 letter to shareholders, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
Interestingly, some value investors, such as David Einhorn of Greenlight Capital, invert this process. Rather than first looking for undervalued stocks based on quantitative screens, for example, low multiples of price to earnings or price to book value, they first identify areas of the market where undervaluation is likely to be present and then search for good companies within that undervalued sector.
When Buffett purchased shares of the Commonwealth Trust Co. of Union, New Jersey, he indentified the reason that was largely responsible for the depressed price of the company's stock. It was because the company was not paying a cash dividend. Identifying this reason reduced the probability that there were other unknown or poorly understood reasons why the stock price was depressed which could have materially reduced the intrinsic value of the company and lead to a permanent loss of capital.
When I attended the Value Investing Executive Education course at Columbia, in June of 2007, our professor, Bruce Greenwald, stressed the importance of asking yourself, when you’ve identified a great bargain, why the market is making it available to you at such a great price. If you can't answer the question, perhaps there are people on the other side of the trade who know something you don't or who are smarter than you. This is why it also makes sense to look carefully at who else has taken a position in the stock or who has not taken a position in the stock. For example, it may be meaningful to observe that, even though newspaper stocks are selling at extremely low multiples, Warren Buffett and Rupert Murdoch have not stepped in and made purchases. What does it tell you when two of the savviest and knowledgeable media investors in the world have passed on stocks that you may deem to be a great value? This is not in opposition to the idea that an investor needs to do his own independent thinking. It is just another fact in the investment appraisal and a recognition that others may have access to more or better information than you do.
Here is a partial list of reasons a stock may be undervalued:
1. The General Market is Down - This is generally the most obvious reason that a stock is undervalued and occurs when the macro view of the economy is poor. It is useful for investors to have some basic tools to value (not predict) the general market so they can prepare as the market becomes undervalued.
2. The Macro View about a Particular Industry is Poor - A classic example of this was in the 90's when the prospects of "Hillarycare" took down healthcare related stocks.
3. The Macro View about a Particular Geographic Area is Poor - In the 1990-1991 recession, California's economy was in bad shape after its real estate market suffered a large decline. This set-up a great opportunity in Wells Fargo's stock which Buffett took advantage of.
4. There is a Severe Short Term Problem which does not Damage the Business Franchise - The classic examples here are Buffett's purchase of American Express after a financial scandal in 1963 and his purchase of Geico in the late 70's after it severely underpriced its insurance risk. In both cases, the problems could be fixed and, more importantly, they did not damage the competitive advantage of American Express's brand and Geico's low-cost structure.
5. The Company has Diversified away from its Core High-Return Business - In the 1980's, Coke diversified into non-core low-return businesses such as shrimp farming and movie making which masked the gold mine they had in the core soft drink franchise. In 1988, when Buffett began to accumulate Coke at around fifteen times earnings, the stock was not overly cheap based on traditional valuation metrics, but this unwise diversification masked the degree to which the market recognized that Coke was a long-term wealth generating machine.
6. The Company Does Not Pay or Has Cut its Dividend - Buffett cites this as the reason that Commonwealth Trust Co. was undervalued when he bought it in 1958. It probably also contributed to the sell-off in high yield U.S. regional banks as they cut their dividends in 2008 to build their capital bases.
7. The Company is Not Followed - If a small company has little or no analysts following the company it may be undervalued because it is neglected. Nobody is getting paid to follow the stock and cheer it on.
8. The Company is a Spin-Off - This is another classic opportunity area. The new company may have excellent economics and prospects which were not understood or appreciated when it was part of its parent company. Joel Greenblatt's book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits provides a great overview of spin-offs.
9. The Company is Emerging from Bankruptcy - The market fails to recognize the value of a newly organized company free of its heavy debt burden or other legacy problems.
10. The Company is Too Complex - This is a favorite area of famed value investor Seth Klarman. If most investors don't understand a given situation or they are unwilling to do the amount of work involved, it may make an undervalued situation available to astute value investors.
- Seth Klarman High Yield stocks, and
- Stocks that Seth Klarman keeps buying