How to Find Undervalued Stocks in the Stock Market | Value Investing

Many of you came looking for list of undervalued stocks. Trust me, if you found that list somewhere on a website or newsletter, by the time it got to you all of those stocks are probably correctly valued by now.  Here is some investment advice on finding your own value stocks.

So instead of giving you a list of stocks, which is probably one of the worst ways to stock pick, let me give you some principles so you can go out and find those gems yourself. In the investment world, by the time someone else tells you about a bargain, it's probably already too late.

The key to finding these great deals is simple. You need to find stocks that are under the radar. That means finding stocks that people don't really know about or has very little news coverage. It also means finding companies that both Wall Street and Main Street aren't really paying attention to.

The essence of value investing is finding those diamonds in the rough that have good fundamentals but the share price isn't reflecting that. Warren Buffett is probably the king of value investors. Here's how he does it.

First, he figures out what a company is worth. For example, maybe he'll take a look at a company making widgets and decides that the company is worth $1 billion. Then he'll go take a look at the company's market cap.

In short, the market cap is basically what the market is saying it's worth. It's calculated by taking the share price and multiplying that by the number of outstanding shares.

So back to the example. If Warren thinks that the widget making company is worth $1 billion and the market cap is currently at $800 million, he sees that as an undervalued stock. It's a bargain because at some point, especially if it's a growing company, that stock will eventually reach or exceed it's market value.

Under the Radar

Warren Buffett finds these diamonds in the rough that no one else is really paying any attention to. If they were, they would see the bargain and buy them up too. So rarely are Buffett's choices obvious when he makes them.

There is, however, the "Buffett Effect". Essentially, once he buys a company, the stock price will rise for the virtue that Buffett owns it. And, once people find out that he has bought a stake in a company, analysts and investors will immediately examine his buy and may go in themselves.

Small Caps Advantage

Where you will find the most undervalued stocks is in small caps and micro caps. First of all, they are small so there are not getting constant attention from news media, analysts and institutional investors. That means if there is pertinent information that should affect the company's value, the investing community is less likely to know about it.

Large cap companies like Disney and Coca-cola are constantly being watched. Every move they make is analyzed, scrutinized and valued. With small caps, the generally run under the radar.

In addition, many large institutional investors stay away from small cap companies. In order for them to make a large enough investment into small companies to make a difference for their gigantic portfolios, they would need to buy a large stake in that company. And this would require getting permission from regulators. So in general, big investors don't buy small cap stocks.

Although you could use an investment vehicle like small cap funds to invest in this cap size category, if you want to find good deals, it's best to look for them yourself.

Investing Strategy

The best way to find undervalued stocks is to start with an industry that you are familiar with. This is important because you need to understand how the underlying business of a company works. This means you need to know what makes a company successful in a given industry.

The companies you are looking for, in addition to being small cap stocks, are those with unique qualities that competitively differentiate them from their competitors. Also, qualities that are hard to replicate, like ones with unique patented technologies or processes.

Once you have this intimiate understanding of the industry, then you can find small companies that have the potential to grow and beat their competitors over time.

There's a fancy term in investing called the efficient market theory. It says that the market takes in all available information and correctly prices assets. So according to this theory, all assets are correctly valued.

We all know that's not completely true even if that is how the market has a proclivity towards. But there's value in understanding this principle because many assets are correctly priced by the market and we need to stay away from those.

Again, most of the stocks that are correctly valued are those that receive the most attention from investors and analysts. The investing community takes all of that data and churns out a valuation based on known information.