Thursday, August 25, 2011

3 Ways to Spot Undervalued Stocks (Stock Picking Redux)

If you and Warren Buffett are of a like mind, then you should also have your "elephant gun" loaded and ready for times such as these, with pervasively depressed stock prices and shaky investor confidence precipitated by S&P's downgrade of US debt a couple of weeks ago.

If you haven't fired your gun yet (like Mr. Buffett, I already have) and you want something more specific than the criteria I presented in these (Part 1 and Part 2) posts, then here are three other signs that you can use to spot undervalued stocks that will most likely provide superior future returns and their corresponding supporting theories.

1. Low price-to-book ratio from "The Cross Section of Expected Stock Returns" by Eugene Fama and Kenneth French

"Price-to-book" is the ratio between the "market value of common equity" to the "book value of common equity," or stock price to "book value of common equity per share," where

Market value of common equity = stock price × total number of outstanding shares
Book value of common equity = total shareholders' equity on the firm's balance sheet
Book value of common equity per share = book value of equity ÷ total number of outstanding shares

According to the study by Fama and French, a low price-to-book is a good indication that a stock is selling for less than it is worth, so is likely to outperform other stocks, other things equal.

2. Significant decreases in stock price over five years from "Does the Stock Market Overreact?" by Werner De Bondt and Richard H. Thaler

This one's a bit harder to accept since going down by a considerable amount intuitively means that there might be something wrong with the stock. But according to the study by De Bondt and Thaler, portfolios consisting of "loser stocks" tend to outperform the market by a significant amount, a result which suggests that while there may be a justifiable reason for a stock's price decline, investors tend to overreact to this information.

3. Less equity issues relative to debt issues from "The Equity Share in New Issues and Aggregate Stock Returns" by Malcolm Baker and Jefferey Wurgler

This idea is based on the concept of information asymmetry: that managers know more about the prospects of a firm than do outside investors, and that managerial decisions can be taken as signals about how the company will perform in the foreseeable future. The results of the empirical study undertaken by Baker and Wurgler show that managers tend to favor equity over debt before periods of low returns and avoid equity before periods of high returns.

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