Stocks on Sale Right Now

The conventional wisdom is that when a company’s stock is falling, there is a distinct reason to stay away. But that may not be the case at all. A key principle of value investing is understanding why the market price of a stock is not always accurate. There are several reasons this may occur:

• A company’s earnings report misses expectations - Corporate earnings reports are one of the most closely watched metrics for investors. Publicly traded companies are required to present investors with detailed financial statements that provide a snapshot of the quarter just completed and guidance for future quarters.
  
  If a company delivers results that are below the expectations of the analysts that cover the company (e.g. have lower revenue and/or earnings per share than expected) shares of the company’s stock may drop lower than the company’s fundamentals suggest should be the case.
• The broader market crashes or corrects - When there is a broad sell-off based on a significant event (e.g. the coronavirus pandemic) it doesn’t discriminate which stocks see their share prices fall. This can be an exceptional time to find stocks of quality companies at bargain prices.
  
  
• A specific company is hit with bad news - From a product recall to a food safety issue, a company or sector can get hit with bad headlines. However, this can lead to a disproportionate response that can take a company’s shares further down than is warranted.
  
  
• Normal fluctuations in the business cycle - Different sectors of the economy perform better at different times of an economic cycle. When a sector is out of favor, it can be a good time to look at finding a quality company selling at a price below its underlying value.

Value investors use a variety of tools to actively look for stocks that may be being disregarded. One of the principals of value investing is that institutional investors and analysts overreact to the news. When this happens, it’s possible for a stock to get decoupled from its fundamentals. This can cause a stock’s price to drop lower than the company’s book value and the stock can become undervalued.

The good news for investors is that there are a variety of online tools such as stock screeners that make it easy to find undervalued stocks. But investors can also look beyond the numbers to see if a company is undervalued. For example, a company that has a proprietary formula or manufacturing process may have a unique selling proposition that allows it to offer consumers lower prices.

One of the many reasons that the internet has made this a golden age for investors is that investors have more access to information than they’ve ever had. The Securities & Exchange Commission (SEC) requires companies to file their financial information prior to their earnings reports. These basic documents such as a company’s income statement, balance sheet, and cash flow statements are available on a company’s web site.

Here are a few other metrics you can use to evaluate the value of a stock.

• Price-to-book (P/B) ratio – This is a stock’s price divided by its equity per share. A book value of less than one suggests that a stock is trading for less than the value of the underlying company’s assets. Value investors use P/B multiples to find stocks with a margin of safety.
• Return on equity (ROE) – This is a company’s annualized net income as a percentage of shareholder’s equity. ROE measures how efficiently a company uses its invested capital to generate profits.
• Debt-to-equity ratio – This is a company’s total debt divided by its shareholders’ equity.
• Current ratio – This is a ratio that expresses how easily a company can pay its short-term obligations. Current ratio is calculated by dividing a company’s current assets by its current liabilities.

There are also a variety of stock screening tools that automatically perform these calculations such as the ones listed above. Many of these stock screeners allow you to sort companies by specific metrics so investors can easily find companies that meet the criteria that they determine.

Before you start to look at the financials of specific companies, you have to narrow down your target list. Here are some guidelines to follow.

• Investors should look at companies they understand – This would seem fairly obvious, but many novice investors make the mistake of investing in companies that they don’t understand. For example, in the dot-com boom many investors were buying shares of companies simply because they had a .com in their name. But the internet in general was a new phenomenon and many investors did not realize that many of these businesses had flawed business models. Sticking with businesses that they know can help investors understand what the company’s numbers actually mean.
• Look beyond a company’s numbers when necessary – You sometimes hear about a company having a “moat”. This simply means that its business is protected, to a certain extent, from competition. A good example of this is a company like Walmart which based on its size and efficiency can simply keep prices lower than many other retailers. Companies with a moat tend to perform well in tough economic times because customers will seek out their business for lower prices.

This also applies to companies that provide the goods and services that are stocked inside a Walmart. You hear the words “defensive stocks”. These are companies that make products that consumers need regardless of the state of the economy.