Is finding undervalued stocks still a mystery for you?

Is finding undervalued stocks still a mystery for you?

Do you know the story of the person looking under a street lamp for a coin that he lost? A passerby offered to help and asked where he lost it. The answer he received was that it was further up the street but there was no light there to search properly!

It is much the same in the stock market. People look for value amongst the arcane models and methods put out by academics and copied by the investment professionals. But they are looking in the wrong place.

They are searching for value in terms of trying to answer questions such as whether or not a particular stock is 30 percent undervalued or 20 percent overvalued. Then they wonder why their performance is mediocre at best. Remember that around 70-80 percent of fund managers, the main people who use these methods, actually under perform the market.

The problem is that they are confusing various static definitions of value with value in terms of performance. No wonder finding undervalued stocks is a mystery for most people.

The aim of successful investing boils down to one thing—being confident that you will get a healthy return. In other words value for an investor needs to be tied to future performance and not whether it appears to be a bargain at the moment.

A key quote from Warren Buffett explains how he approaches this.“Unless we see a very high probability of at least 10% pre-tax returns," he wrote, "we will sit on the sidelines.” You might be thinking, “Wait a minute, Buffett gets a much higher return than this.” You would be right in thinking this.

The point is that this is really his worst case scenario. It is like locking in a minimum of 10 percent and leaving open the possibility of much higher returns which in Buffett’s case is an average of over 20 percent per year.

In other words, a true undervalued stock is first of all a quality company and secondly it is selling at a price so that under a margin of safety you can be confident of receiving a strong return.

This is precisely what Conscious Investor® does.

• It starts by identifying great companies in terms such as management performance, strong and consistent growth and minimum debt.
• Once you have decided on a particular company, the second step is to calculate the expected return over your investment period under your margin of safety. For example, you can calculate your performance over the next five years if the growth in earnings dropped by 50 percent from its past rate.

In this way Conscious Investor helps you hone in on companies that give you true value as an investor.


http://www.conscious-investor.com/whatis/findingvalue.asp

Will You Be Satisfied With 7% Returns?

Will You Be Satisfied With 7% Returns?
By Alex Dumortier, CFA
March 18, 2009 Comments (41)

7.2%.
That's what Jeremy Grantham recently predicted stocks will return -- after inflation -- on an annualized basis over the next seven years.

Is that good enough for you?
Who on earth is Jeremy Grantham? Jeremy Grantham is the co-founder of investment firm GMO, which currently has approximately $90 billion in assets under management.

Grantham is often dismissed as a "perma-bear" when his views go against Wall Street's institutionalized optimism -- but the truth is, he's a rock-solid investment thinker, grounded in reality, who calls 'em like he sees 'em.

He believes that "mean reversion is the most powerful force in financial markets." In other words, periods of abnormally high returns must be balanced out by periods of abnormally low returns, and this holds true across the gamut of different assets, whether it be commodities, stocks, or bonds.

On that basis, at the end of 2001, Grantham predicted that the S&P 500 would suffer an annualized decline of 1.1% over the following seven years -- which was decidedly optimistic, since the annualized real return turned out to be negative 3.9%.

In July 2007, as the credit crisis was in its infancy, Grantham wrote: "In five years, ... at least one major bank (broadly defined) will have failed." We've all witnessed the multiple failures, rushed takeovers, and government rescues in the financial sector since then.

So, it's worth taking his predictions seriously.

7%? Seriously?
It may be hard to imagine 7% annual returns (after inflation, no less!) right now, what with the S&P 500 down approximately 50% from its all-time high in October 2007, but that decline has, in fact, set the stage for investors to earn 7% -- near the average historical return on stocks -- going forward.

The drop has been a source of enormous pain for investors -- but from the point of view of the prospective stock buyer, it's a great opportunity since stocks are at lower valuations than they have been in years.

In fact, Grantham called U.S. blue chips "manna from heaven"; indeed, when the credit crisis began to escalate, he said "they were about as cheap, on a relative basis, as they ever get."
I wanted to verify that claim, and I was able to confirm that over one in four non-financial stocks in the S&P 500 are cheaper in terms of their price-to-book value multiple than they have been in over 14 years. They include these superb companies:

Price/Book Value
Forward Price/Earnings

Oracle (NYSE: ORCL)
3.3
10.4
Cisco Systems (Nasdaq: CSCO)
2.5
14.5
Procter & Gamble (NYSE: PG)
2.3
12.7
eBay (Nasdaq: EBAY)
1.3
8.4
CVS Caremark (NYSE: CVS)
1.1
12.3
General Electric (NYSE: GE)
1.0
8.1
Alcoa (NYSE: AA)
0.4
N/A
Source: Capital IQ, a division of Standard & Poor's, as of March 16, 2009.

But what if you aren't satisfied with 7% returns?

Getting to 7% *plus*
Grantham's prediction is based on the S&P 500, in aggregate, being fairly valued (he's currently pegging its fair value at 950). And if you pay fair value for the index, you can expect to earn the weighted average return that the underlying companies earn on their equity.

But within the S&P 500, some stocks will likely be overvalued, and some will likely be undervalued. If you're able to buy an individual stock for less than its fair value, that margin of safety will turbo-charge your expected return beyond the company's accounting return on shareholders' equity.

Grantham expects a subset of U.S. stocks -- those he labels "high quality" -- to produce after-inflation annualized returns of 11.2% over the next seven years. Four percentage points on an annualized basis is an enormous difference -- and gives investors plenty of incentive to identify those "high quality" stocks.

Although Grantham doesn't directly define "high quality," he provides some clues in an interview with Forbes in which he said, "And the best bet, for my money, then and now, a year later, was to buy the great franchise companies, the great quality companies." This suggests that he favors companies that possess a moat -- a sustainable competitive advantage -- and that earn excess returns over their cost of capital.

Helping you earn better returns
No investor is "condemned" to 7% returns going forward -- and neither are we promised them. Investing -- at reasonable prices -- in excellent businesses that are likely to grow is the best strategy for securing your long-term returns.

Of course, even among stocks that are perceived as "high quality," you can expect a range of different returns. The trick is identifying which stocks are genuinely undervalued.


Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Procter & Gamble is a Motley Fool Income Investor pick. eBay is an Inside Value and a Stock Advisor recommendation. The Fool owns shares of Procter & Gamble.

Read/Post Comments (41)

http://www.fool.com/investing/value/2009/03/18/will-you-be-satisfied-with-7-returns.aspx

Ben Graham Checklist for Finding Undervalued Stocks

In addition to identifying and quantifying important value components, Graham left us with an assortment of general stock selection rules. He created a number of checklists at different times in his career to serve different investment objectives and portfolio strategies. The checklists review different aspects of a company's financial strength, intrinsic value, and the realtionship with price.

Here is a
Ben Graham Checklist for Finding Undervalued Stocks

Criterias

Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.

Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.

Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.


If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham.

If you're income oriented, Graham recommended paying special attention to items 1 through 7.

If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.

If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.

Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.

The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.

Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html


Reference: 20.11.2008 - KLSE MARKET PE