10 Reasons Why a Stock Can Be Undervalued

On Friday, July 17, 2009, I wrote that 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.

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. (Look for future posts on this subject.)

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 Geography 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.

Share

Leave a Reply

Your email address will not be published. Required fields are marked *